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Full text of "Tax revision issues, 1976 (H.R. 10612)"

[COMMITTEE PRINT] 



TAX REVISION ISSUES— 1976 
(H.R. 10612) 



1 



TAX SHELTER INVESTMENTS 



Peepared for the Use of the 
COMMITTEE ON FINANCE 

BY THE STAFF OF THE 

JOINT COMMITTEE ON INTERNAL REVENUE 
TAXATION 




APRIL 14, 1976 



U.S. GOVERNMENT PRINTING OFFICE 
69-342 O WASHINGTON : 1976 JCS— 8-76 



CONTENTS 



Introduction: Page 

1. Overview of Tax Shelters 3 

2. General Approaches to Revision 23 

3. Real Estate 25 

4. Farm Operations 33 

5. Oil and Gas 61 

6. Movie Films 67 

7. Equipment Leasing 81 

8. Professional Sports Franchises 89 

9. Prepaid Interest 99 

10. Partnership Provisions 107 

11. House Bill — Limitation on Artificial Losses (LAL) 117 

12. House Bill— Other Tax Shelter Provisions 123 

(III) 



INTRODUCTION 

This pamphlet presents backgTound information regarding tax 
sheher areas. The areas discussed in the pamphlet include real estate, 
farming, oil and gas, movie films, equipment leasing, professional 
sports franchises. The pamphlet also includes a discussion of the use 
of limited partnerships as well as the tax aspects of the partnership 
provisions. 

Initially, the pamphlet provides a general overview of tax shelters 
indicating the elements of a tax sheltered investment, the use of 
limited partnerships, a summary of tax sheltered investments and 
their related tax deductions, a summary of the provisions in the Tax 
Reform Act of 1969 affecting tax shelters, the public syndication of 
tax shelter investments, and the current positions of the Internal 
Revenue Service and the Securities and Exchange Commission with 
regard to related aspects of tax shelter investments. 

The pamphlet then provides a discussion of each of the areas 
setting forth a description of the shelter including, in most cases, an 
example of an investment in the area, then a discussion of present 
law, followed by a brief analysis of several of the issues which are 
argued for and against the tax provisions. 

Finally, the pamphlet provides a brief description of the provisions 
in the House-passed bill (H.R. 10612) dealing with tax shelters. One 
or more pamphlets discussing alternative proposals for dealing with 
tax shelters and related matters, will be issued subsequently. 

(1) 



1. OVERVIEW OF TAX SHELTERS 
General 

Over the last several years, there has been a great deal of concern 
about high income individuals who are able to eliminate or substan- 
tially reduce their tax liability through the use of various tax prefer- 
ences. Congress reviewed this problem in 1969, and the Tax Reform 
Act of that year contained many provisions to deal with these prefer- 
ences, either directly or indirectly. Also, the Congress enacted a mini- 
mum tax which was intended to cover those situations where Congress 
believed a tax preference should be allowed, to serve as an incentive 
for particular kinds of investment, but also believed that it was not 
desirable to allow taxpayers to cumulate those preferences to such an 
extent that the taxpayer might escape tax altogether. 

Since 1969, however, there has been a substantial growth in the pro- 
motion of investments which are advertised as "tax shelters." Although 
these take a great variety of forms, in general, they all allow taxpayers 
to offset certain losses not only against the income from those invest- 
ments but also against the taxpayer's other income, usually from his 
regular business or professional activity. A major purpose of these 
investments for most taxpayers is to generate net losses in the initial 
years of the investment and thereby permit investors to reduce the 
tax liability on their regular income. 

There are several elements that make up a tax shelter investment 
(though not all of these elements are found in all shelters). The 
first is the "deferral" concept where deductions are accelerated in 
order to reduce the tax liability of an individual in the early years of 
the transaction instead of matching the deductions against the income 
which is eventually generated from the investment. This deferral of 
tax liability fi'om earlier years to future years can be viewed as an 
interest-free loan by the Federal Government, repayable when, and 
as, the investment either produces net taxable income, is sold or is 
otherwise disposed of. 

.The second element of a tax shelter is "leverage" whereby a tax- 
payer maximizes his tax benefits, as well as his economic situation, by 
using borrowed funds in his investments to pay the expenses for 
which accelerated deductions are received. The individual's position 
is enhanced when the borrowing; is on a nonrecourse basis, which means 
that he is not personally liable to repav the loan, but his personal 
investment risk is limited to his equity investment. Limited partner- 
ships generally are used in tax shelter investments so that the tax- 
payer can invest as a limited partner with no liability other than the 
amount of equitv that he has advanced from his own funds. 

In addition, a third tax shelter element for many investments is "con- 
version" of ordinary income to capital gains at the time of a subsequent 

(3) 



sale or other disposition of the asset. Conversion occurs when the por- I 
tion of the gain which reflects the accelerated deductions taken against '' 
ordinary income is taxed as capital gains. (Also, if the taxpayer is in a 
lower income tax bracket in the later years, he effectively "converts'' the 
tax rate, too.) 

The following discussion deals generally with tax shelter investments 
as an overview to the whole area. The analysis of each activity (such 
as, real estate, farming, oil and gas, equipment leasing, movies, etc.) 
will be dealt witli more specifically in subsequent parts of this 
pamphlet. i 

Elements of a Tax Shelter Investment 

Deferral 

Deferral commonly arises in situations where taxpayers make in- 
vestments in activities or businesses which use the cash basis method of 
accounting and are permitted to take certain deductions (such as cattle 
feed or vineyard development costs) into account for tax purposes in 
the first year and the other early years of the shelter investment before 
the investment produces any income. Deferral also occurs where tax- 
payers are permitted to accelerate certain deductions (such as de- 
preciation) to the early years of an investment transaction. 

The "bunching" of deductions in the first years, rather than ratably 
over the life of the property, is used to offset (shelter) an individual's 
other income. That is, excess accelerated deductions result in losses 
which are then used against his other investment and earned income - 
and may significantly i-educe the individual's tax liability. However, 
the taxes that are reduced in the earlier years may be shifted to later 
years when the investment begins to generate income, and many_of 
the offsetting deductions have been used and are thus no longer avail- 
able. Taxpayers in this situation have frequently found it advanta- 
geous to invest in another tax shelter to provide a "rollover" or further 
deferral of the taxes. 

The net effect of deferral may be viewed as an interest-free loan to 
the taxpayer from the Federal Government during the period of 
the tax deferral. Over a period of years, this "loan" can be worth a sub- 
stantial amount of money. For example, if a taxpayer has $100,000 of 
accelerated deductions and invests the tax savings in 7% tax-exempt 
bonds (with interest compounded annually) his money will double in 
less than 11 years. In other words, deferral can be worth as much as 
total tax forgiveness after a period of time. 

In addition, in many cases, especially where leverage is used, as 
discussed below, a tax shelter investment also results in a taxpayer 
completely recovering his investment (and in some cases more) by the 
acceleration of the deductions. This is often the case for taxpayers in 
the nO-percent or higher tax brackets. Thus, not only does the Federal 
Government provide an interest-free loan, but in a sense the Govern- 
ment provides the risk capital to high bracket taxpayers to enter into 
these investments. 

It is important to note that this deferral treatment benefits those in 
the higher brackets proportionately more than it benefits those in the 
lower brackets. For example, for each $100 deduction, a taxpayer in 
the 70-percent bracket will save $70 by taking that deduction against 



his income. On the other hand, a taxpayer in the 20-percent bracket 
will save only $20 when that $100 deduction is used to offset his income. 
This is particularly important in a tax shelter investment because of 
the various risks that are involved. In other words, the interest free 
loan for the upper income taxpayer is $70 ; the interest free loan for the 
lower bracket taxpayer is considerably less. 

It should be noted that the tax benefits from deferral are greater in 
some tax shelters than in others simply because the deferral is for a 
longer period than for other investments ; that is, taxes are clef erred 
over a longer period of time. In the case of the shorter deferrals it is 
possible for an individual to rollover his investment ; that is, to make 
another tax shelter investment to provide new accelerated deductions 
and thus defer tax liability further into the future. 

Effect of progressive rate structure. — One of the risks in a tax shelter 
is that the investment may result in a true economic loss where the 
taxpayer may lose his entire investment. If this were the case (not tak- 
ing into account the use of borrowed money, as discussed below) , a tax- 
payer in the 70-percent bracket would lose only $30 of his own money ; 
whereas, a taxpayer in the 20-percent bracket would lose $80. There- 
fore, the high bracket taxpayer would be willing to make riskier 
investments because his potential net loss (that is, the tax benefit less 
any economic loss) is less. In effect, the Federal Government finances 
more of the investments, and take more of the risks, for a high bracket 
taxpayer than a low brack taxpayer. 

It should be noted that in the case of a taxpayer with only "earned 
income" subject to a maximum tax rate of 50 percent, tax shelter deduc- 
tions reduce income at the 50 percent and low^er rates. However, when 
the tax shelter investment is disposed of at other than capital gains 
rates, gains may be taxed as high as 70 percent, since they will be 
investment income and thus not eligible for the 50 percent maximum 
rate on earned income. 

Leverage 

The second element of a tax shelter investment is "leverage," which 
is the use of borrowed money by an individual in the investment. 
Generally, an individual will borrow money (or money will be bor- 
rowed on his behalf) which will equal or exceed his equity invest- 
ment. There are two benefits in the use of borrowed funds, the first 
being an economic benefit and the second being a tax benefit. From 
an economic standpoint, the more that an individual can use borrowed 
money for an investment the more he can use his own money for other 
purposes (including other investments) and the more he can make on 
an investment which is profitable. From a tax standpoint, borrowed 
funds are treated in the same manner as a taxpayer's own funds that he 
has put up as equity in the investment. Since a taxpayer is allowed de- 
ductions not only with respect to his equity but also on the borrowed 
funds, he can maximize deferral by incurring deductibe expenditures 
which exceed his equity investment. 

A simple illustration of the use of leveraging in tax shelter invest- 
ments is as follows : Assume the investment requires $100,000 of cap- 
ital. If an individual invests $10,000 of his own money and is able to 
borrow $90,000 to meet the $100,000 requirement, for tax purposes he 
is treated as having $100,000 in the investment. This means that if 



6 

there are accelerated deductions of $20,000 in the first year, the in- 
dividual, if he is in the 70-percent bracket, would be reducing his tax 
liability by $14,000. In this case, the tax deduction in the initial year 
($20,000) would be $10,000 more than the equity capital invested and 
his tax savings would be $4,000 more than the amount originally in- 
vested ($10,000). This individual would be financing his investment 
completely with what can be referred to in effect as an interest-free 
loan from the Federal Government. In this example above, a taxpayer 
in the 50-percent bracket would recover his entire investment in the 
initial year; that is, if he invests $10,000 of his own money and is 
allowed to deduct $20,000, he receives back by way of reduction of 
his tax liability the $10,000 he invested. This is the reason why most 
tax shelter investments are advertised for taxpayers in the 50-percent 
bracket and above. 

A taxpayer in the 20-percent bracket who invests the same $10,000, 
as in the above example, would only receive back $4,000 from the same 
$20,000 tax write-off in the first year and, therefore, he is still out of 
pocket $6,000 in the first year. Not only is the low bracket taxpayer 
less likely to have the funds to invest in these investments but the 
Federal Government does not provide him the same subsidy as it does 
for the high bracket individual. 

As can be seen from this example, in the initial years, the risks to a 
high bracket taxpayer are rather minimal because in the normal tax 
shelter inyestment, he would recover the entire auiount of his own in- 
vestment in the year it is made through tax deductions. It should be 
noted, however, that even if the investment fails, there is usually some 
recovery (and sometimes substantial recovery) of previous writeoffs 
where the investor would be liable for tax on the constructive income 
he is required to recognize when the shelter terminates. This is often 
referred to as the ''phantom gain*"; whei'e there is gain for tax pur- 
poses, even though the investment does not generateeconomic income 
or positive cash flow. In other words, the taxpayer is required to repay 
his interest free loan from the Government, at least to the extent of any 
nonrecourse borrowings which he was previously able to deduct. 
(Sometimes this repayment must be made in full, and sometimes only 
m part, if there is a "conversion"' feature to the shelter, as discussed 
below. ) 

The use of leverage has increased significance when an investor is 
not even liable on the borrowed money, which is often the case in 
tax shelter investments. This is what is referred to as "nonrecourse fi- 
nancing." Where a partnership (usually a limited partnei-ship) is being 
used as the investment vehicle, a loan may be made to the partnership 
so the partnership assets are subject to liability but the investors are 
not personally liable for the loan. However, under partnership tax reg- 
ulations, the limited partner investor is entitled to increase his basis in 
his investment bv the amount which is treated as his proportionate 
share of the liability (even though in fact he has no such liability). 
(A pai'tner may deduct partnership losses to the extent of jiis basis.) 
Thus, the investor is able to take tax Avrite-offs on account of the accel- 
erated deductions not only for the money he invested (on which he is 
at risk) but, more significantlv, also on his share of the nonrecourse 
aspects of tax shelter investments. (Nonrecourse loans are discussed 
below in connection with limited partnerships.) 



Conversion of ordinain/ incoine into capital gains 
A third aspect which is present in some tax shelter investments is 
referred to as "conversion,'' which is the process of converting ordinary 
income deductions into capital gains. 

When a taxpayer depreciates an asset, he takes a deduction against 
his ordinary income (and thus reduces taxable ordinary income) for 
depreciation. If the asset is a capital asset when it is sold and the pro- 
ceeds exceed basis.^ there is a taxable gain. However, even though the 
previous reduction in basis (depreciation) reduced ordinary income, 
this gain may be taxed as capital gain. When the gain is a capital gain, 
the effect of the sale is to convert ordinary income, that is the income 
which was reduced by the previous accelerated deductions at the mar- 
ginal bracket of the taxpayer, to capital gains taxed at the preferen- 
tial capital gains rates. 

In several cases. Congress has dealt with this situation by requiring 
a portion of the gain on a sale or other disposition to be treated as ordi- 
nary income rather than capital gains, to the extent of accelerated 
depreciation deductions (and in the case of personal property, to the 
extent of all depreciation). This is Avhat is referred to as "recapture." 
The taxes on the ordinary income that have been deferred through the 
taking of accelerated deductions in earlier years are recaptured at the 
time the propertv is disposed of. Although there are several recapture 
rules in present law today, the recapture rules do not apply to all tax 
shelter investments. (In addition, the "recapture" applies only to 
prevent the conversion of ordinary income to capital gains; it does 
not apply to the deferral factor.) 

Use of Limited Partnerships 

The form of entity most commonly chosen to maximize tax benefits 
in a tax shelter investment has been the limited partnersliip, which, 
upon meeting certain requirements, is subject to the partnership rules 
of the Internal Revenue Code. In general, a partnership is not con- 
sidered a separate entity for tax purposes : rather the individual part- 
ners are taxed currently on their share of the partnership gains and 
can deduct partnership losses to the extent of the basis of their part- 
nership interest. 

When an investor enters a partnership, his basis in the partner- 
ship generally includes the amount he invested and his share, if any, 
of the partnership liabilities. In this regard, the income tax regula- 
tions (Regs. § 1.752-1 (e) ) provide that a limited partner may include 
in the basis of his partnership interest his share of the nonrecourse 
loans to the partnership even though he is not personally liable on the 
debt. (Such loans usually are secured only by the partnership prop- 
erty.) Nonrecourse financing facilitates the use of limited partner- 

^ The initial tax basis of property usually is its cost but this tax basis is 
reduced to the extent that the property is being depreciated : that is, to the extent 
the total capital expenditures liave been amortized over the life of the proner<"f^ 
at the time of the disposition. Thus, to the extent the depreciation or other capi- 
tal expenditures aie accelerated, the tax liasis of the projierty is reduced faster in 
the earlier years. If the property is sold, the gain may be greater because the tax 
basis is lower than it otherwise would be if accelerated deductions had not been 
taken. 



8 

ships for tax shelter investments because the investor is able to limit 
his liability to the amount he has actually invested but use nonrecourse 
loans obtained by the partnership to substantially increase his basis 
and thus increase his tax deductions. 

More specifically, these general principles apply to limited partner- 
ships in tax shelter investments : 

1. The limited partnership is not a taxpaying entity, but instead 
is a tax conduit, the partners I'eporting their distributive shares of 
partnership income or loss. 

2. Subject to the restriction that its purpose not be to avoid or \ 
evade tax, a limited partnership agreement may provide for the i 
manner in whicli the partnership's items of income, gain, loss, 
deduction or credit will be allocated among the partners. 

3. The amount of losses which a partner may deduct for a par- 
ticular year is limited to the amount of the adjusted basis of his 
partnership interest as of the end of the year. At the inception of 

a partnership, the adjusted basis of the partner's partnership i 
interest equals the sum of his capital contribution to the partner- i| 
ship plus his share, if any, of partnership liabilities. In the case of i 
a limited partnership, a limited partner's share of the partner- 
ship liabilities is his pro rata share (the same proportion in ' 
which he shares profits) of all liabilities with respect to which 
there is no personal liability ("nonrecourse liability"). This rule, 
where a limited partner's adjusted basis in his partnership inter- 
est is increased by a pro rata amount of nonrecourse liability, is 
one of the cornerstones of tax shelter investments, allowing the 
investor, in many cases, to currently deduct amounts in excess of ' 
his actual investment. ^j. \ 

The limited partnership is generally preferred over the general ; 

partnership because the limited partners, who are passive investors in ''. 

most cases, have limited liability for the debts of or claims against the ' 

partnership. 

Corporations 

The corporate form of doing business generallv does not lend itself 
to tax shelter investments by individuals since the corporation is the 
taxpaying entity and, therefore, the tax incidents of its operation 
remain at the corporate level and do not pass through to its share- 
holders. The one exception to this treatment is for Subchapter S • 
corporations. To a great extent, the tax incidents of a Subchapter S 
corporation's operations pass through to its shareholders. However, 
there are certain tax limitations applicable to the Subchapter S corpo- 
ration (and to its shareholders) which are not imposed upon a limited 
partnership under the partnership provisions. These limitations gen- 
erally make Subchapter S corporations less attractive as a vehicle for 
tax shelter investments. 

As previously noted, one of the principal tax shelter benefits ob- 
tained under the partnership tax provisions is that the adjusted basis 
of an individual partner in his partnership interest not only includes 
his cash investment but also a pro rata share of any nonrecourse 
liability of the partnership. By contrast, the adjusted basis of the 
shareholders of a Subchapter S corporation in their stock includes 
their investment in the stock and any loans they may have made 



to the corporation, but, most signficantly, does not include any por- 
tion of the corporation's liabilities. In both cases, that of the Subchap- 
ter S corporation shareholder and the limited partner, it is the ad- 
justed basis in partnership interest or stock, as the case may be, which 
serves as the upper limit on the amount of loss that may be deducted 
by the shareholder (partner) in a given year. Thus, in comparison to 
the limited partner, the Subchapter S corporation shareholder is 
severely limited in terms of the amount of losses, and therefore tax 
shelter, available. 

Other limitations which apply only to Subchapter S corporations 
are: (1) A Subchapter S corporation may not have more than ten 
shareholders; (2) Trusts may not be shareholders of a Subchapter S 
corporation; (3) A Subchapter S corporation may not have two or 
more classes of stock; (4) No more than 20 percent of a Subchapter S 
corporation's gross receipts may be derived from passive investment 
income, which includes, among other things, certain types of rental 
income; (5) No provision may be made for special allocation of losses 
and other items to the shareholders, these items being allocated strictly 
in proportion to stock ownership. 

Summary of Major Tax Shelter Investments and Their Related 

Tax Deductions 

This part of the overview discussion presents a list of the business 
activities which investors often enter chiefly for tax benefits from 
special kinds of deductions. This part also sets forth the principal 
deductions which are relied on for "tax shelter" in each industry. The 
main characteristics of these deductions is that they are all accelerated 
in some manner, providing for the deferral of taxes.^ In each of these 
shelters leverage can be an important factor which can magnify the 
deductions which are indicated. 

Specialized investment area Key shelter-producing deduc- 
tions or other benefit 
A. Real estate 

1. Residential rental apart- a. Interest on construction period 
ments, FHA-subsidized housing, financing, 

office buildings, shopping centers, b. Construction period taxes. 

c. Accelerated depreciations. 

d. Capital gain on sale. 



2. Land. a. Current expensing of taxes, in- 

terest and certain other land 
development costs, 
b. Capital gain on sale. 



^ Many of the deductions listed are available only to taxpayers who report on 
the cash method of aecovinting, and thus can deduct expenses when and as 
they pay them and are not required to use inventories in their business opera- 
tions. 



10 



1 



Specialized investment area Key shelter-producing deduc- ) 

tions or other benefit 

3. Rehabilitation of low-income a. 60-month depreciation, 
rental housing. b. Capital gain on sale. 



B. Farming 

1. Cattle feeding. a. Feed costs (including prepaid* 

feed costs), 
b. Other direct costs of fattening, 
the animals. 



2. Cattle breeding (also breed- a. Feed and other raising ex- 
ing other kinds of livestock such penses (including breeding 

as horses, mink, hogs, etc. ) fees) . 

b. Accelerated depreciation of. 

purchased animals. ' 

c. Additional first year deprecia- 

tion. 

d. Investment credit (except on 

horses. ) 

e. Capital gain on sale. 



3. Raising certain vegetables or Expensing of growing costs, 
plants. 



4. Shell eggs. a. Costs of laying hens. 

b. Raising costs (including feed), 



5. Agricultural crops, vine- a. Development and raising costs. 
yards, fruit orchards, Christmas b. Accelerated depreciation on 
t'^^^s.^ underlying grove (aftercrop 

matures. 

c. Investment credit. 

d. Capital gains on sale. 



6. Thoroughbred horse racing, a. Maintenance costs. 

b. Stud fees. 

c. Capital gain on sale. 



1 citrus and almond grove costs must be capitalized (sec. 278). 



C. Oil and gas drilling 



11 



a. Iiitano^ible drillino; costs. 

b. Capital ^ain on sale. 



Specialized investment area 



Key shelter-producing deduc- 
tions or other benefit 



D. Equipment leases (e.g., com- a. Accelerated depreciation or 5- 
puters, airplanes, ocean-going year amortization. 

vessels, railroad cars, CATV b. First-year "bonus" deprecia- 
systems, etc.) tion. 

c. Investment credit (corporate 
lessors only). 



E. Motion pictures 

1. Purchase of completed pic- a. Accelerated depreciation, 
ture. b. Investment credit. 



2. Production of a picture. Expensing of production costs. 



F. Professional sports 
franchises 



G. Deductions available 
generally 



a. Rapid depreciation of player 

contracts. 

b. Payroll and other operating 

costs. 

c. Capital gains. 



a. Interest on borrowed funds 

used to finance costs of ac- 
quiring the investment and 
to pay some of the deductible 
expenses. 

b. Real estate, sales and use taxes. 

c. Various prepaid expense items. 

d. Miscellaneous commissions, fees 

for professional services, etc. 



12 

Summary of Provisions in Tax Reform Act of 1969 Affecting Tax 

Shelters 

The Tax Reform Act of 1969 was a substantive and comprehensive 
reform of the income tax laws oenerally and dealt either directly or in- 
directly with a number of the provisions involving- tax shelter invest- 
ments. Although many tax ])references were dealt with directly by the 
1969 Act, in most cases these were not eliminated but only reduced in 
certain respects. Certain tax preference provisions were not affected at 
all by the 1969 Act because it was believed inappropriate to make any 
change in those areas at that time. However, since 1969 (and especially 
in the early 1970's), tax preferences have been packaged and pro- 
moted in tax shelter investments to an increasingly significant extent. 

A brief sununary of the 1969 revisions and reforms relating to tax 
shelter investments follows: 

Real estate 
In the case of real estate, the 1969 Act substantially limited real 
estate depreciation allowances. The 200-percent declining balance 
method and other accelerated forms of depreciation were restritced to 
new residential housing. Depreciation with respect to other new real 
estate was i-estricted to the 150-percent declining balance method. Used 
properties acquired in the futui-e were limited to straight line depreci- 
ation, except for used residential housing which was made eligible for 
allowances at 125 percent of the straight line method where the prop- 
erty still has a useful life of more than 20 years. In addition, stricter 
recapture rules were imposed, particularly for nonresidential proper- 
ty, so that a larger i)roportion of gain on the sale of iDroperty (which 
resulted from accelerated depreciation allowances taken previously^ is 
taxed as ordinary income. 

Farm operations 
In the case of farui operations, the 1969 Act made a series of 
changes. Taxpayers deducting farm losses against their non-farui 
income generally must treat capital gains arising on the subsequent 
sale of farm assets as ordinary income. For individuals, this recapture 
rule applies only to losses over $25,000 and only if nonfarm income 
is over $50,000. The Act also provided for the recapture of depreciation 
on the sale of livestock and a more effective treatment of hobby losses. 
The holding period for capital gain treatment with respect to cattle 
and horses was extended, provision was nuide for the recapture of 
soil and water conservation or land-clearing expenditui'es on the sale 
of farm land held less than 10 years, and the costs of developing citrus 
groves were required to be capitalized. 

Natiiral resources 
In the case of natural resources, the Act made several significant 
revisions, the main one being the reduction of the percentage deple- 
tion allowances. The percentage depletion rate for oil and gas wells 
was reduced from 27^/2 percent of gross income to 22 percent. (The 



13 

Tax Reduction Act of 1975 eliminated percentage depletion for the so- 
called "majors" and provided for a reduced allowance for so-called 
"independents.") In the 1969 Act, the depletion rate was also cut to 22 
percent for minerals eligible for a 23 percent rate under prior law and 
to 14 percent for most minerals eligible for a 15 percent rate under 
prior law. 

Carvecl-out and other production payments (including ABC trans- 
actions) were treated as if the payments were loans by the owner of 
the payment to the ow^ner of the mineral property. This prevented 
the use of carve-outs to increase percentage depletion payments and 
foreign tax credits. It also eliminated the possibility of purchasing 
mineral property with money wdiich was not treated as taxable income 
to the buyer. Finally, recapture rules were applied to mining explora- 
tion expenditures not subject to recapture under prior law and the 
foreign tax credit w^as disallow^ed to the extent foreign taxes were 
attributable to the deduction allowed against U.S. tax for percentage 
depletion. 

Capital gains and losses 
The 1969 Act eliminated the alternative tax on long-term capital 
gains for individual taxpayers to the extent they have capital gains 
of more than $50,000. Long-term capital gains up to the first $50,000 
received by individuals continues to qualify for the 25 -percent alterna- 
tive capital gains tax rate. The maximum tax rate on that part of long- 
term capital gains above $50,000 was increased (over a 3-year period) 
to 35 percent (one-half of the 70-percent top tax rate applicable to 
ordinary income) . The alternative tax rate on corporate long-term cap- 
ital gains income was increased (over a 2-year period) from 25 percent 
to 30 percent.^ 

Interest deduction 
The 1969 Act limited the deduction for interest paid or incurred by 
a taxpayer (other than a corporation) on funds borrow^ed for invest- 
ment purposes to 50 percent of the interest in excess of the taxpayer's 
net investment income, his long-term capital gains and $25,000. The 
disallowed interest, however, may be carried over to subsequent years. 
(This provision had a 2-year delay in effective date.) 



^ In addition, the Act required net long-term capital losses (in excess of net 
short-term capital gains) of individuals to be reduced by 50 percent before they 
offset ordinary income. (The limitation on the deduction of these losses against 
ordinary income was retained at ^1,000. Where separate returns were filed, 
the deduction of capital losses against ordinary income was limited to $500 for 
each spouse.) Ordinary income tax treatment instead of capital gains treat- 
ment was provided for (1) gains from the sale of memorandums and letters 
by a person whose efforts created them (or for whom they were produced), (2) 
transfers of franchises, trademarks, and trade names where the transferor re- 
tains significant rights, powers, or continuing interests, and (3) contingent pay- 
ments received under franchises, trademark, or tradename transfer agreements. 
(In addition, corporations were allowed a three-year loss carryback for net 
capital losses.) 



14 

Minimum tax 
To supplement the specific remedial provisions of the Act in curtail- 
ing; tax preferences, a minimum tax was enacted which applies to both 
individuals and corporations. It is computed by (1) totaling the 
amount of tax preferences received by the taxpayer (from the cate- 
oories of tax preferences specified in the Act), (2) subtracting from 
this total a $30,000 exemption and the amount of the taxpayer's regu- 
lar Federal income tax for the year (plus any carryovers from prior 
years), and (3) applying a 10-percent tax rate to the remainder. The 
maximum tax is payable in addition to any regular income taxes to 
which the taxpayer is subject. 

Maximumj tax on earned income 

The 1969 Act provided that the maximum marginal tax rate ap- 
plicable to an individual's earned income is to be 50 percent. It was 
concluded that the higher rates of tax (that is, the top marginal rate 
of 70 percent), were inappropriate in the case of earned income. 

In addition, the 50-percent limit on the tax rate applicable to earned 
income was adopted as a means of reducing the pressures for the use 
of tax avoidance devices. As a result, for purposes of the maximum 
tax provision, earned income eligible for the 50-percent top rate is 
reduced by tax preferences in excess of $30,000. 

Public Syndication of Tax Shelter Investments 

Tax shelters are not a new form of investment, nor were they 
created by the public syndicators of interests in real estate and other 
limited partnerships. The advantage of owning an apartment 
building, for example, both for current income and for accelerated 
depreciation, has long been familiar to doctors, lawyers, and other 
high-income professionals and businessmen. Real estate syndicates of 
individuals have been formed for many years, usually involving 
a builder and a small group of individuals who personally know each 
other. However, the widespread public sales of shares in investments in 
real estate, farming, oil drilling, motion pictures and the like (many of 
which involve registering the offering with the Securities and Ex- 
change Commission and selling it like a stock interest) has been a 
phenomenon of recent years, reflecting efforts by promoters to pass 
through tax shelter benefits to passive outside investors. 

This form of mass merchandising, which has received much public- 
ity in recent years, is basically a reflection ratlier than a cause of tax 
shelter benefits in present law. Some critics of tax shelters believe, 
however, that the public syndication of specialized investments to 
absentee owners has created a preoccupation with tax benefits (rather 
than with the economic merits and risks of the project) to the neglect 
of future tax liabilities. 

Some of those who share this view argue that the tax provisions 
which Congress intended as incentives work well so long as they are 
not carried to extremes, but when an investment is made chiefly to 
intensify "tax writeoffs." the tax rules become distorted and cease to 
work as they were intended. 



15 

Table 1 shows the trend since the Tax Reform Act of 1969 in the 
number and vohime of publicly syndicated tax shelter offering regis- 
tered with the National Association of Securities Dealers. 

The trend indicates that publicly syndicated tax sheltering offerings 
since the 1969 Act increased from 1970 through 1972 but began to 
decrease in 1973 and then started to drop off sharply in 1974 and 1975. 
It should also be noted, however, that public syndications registered 
with the National Association of Securities Dealers make up only a 
very small number of the actual tax shelter investments. There are 
many more private syndications (or public syndications) which are 
not required to be registered. Moreover, this decline may be explained 
in part by the general economic downturn that existed in 1974 and 
most of 1975. 



16 



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18 

Current Positions of the Internal Revenue Service With Regard 
to Tax Shelter Investments 

Over the last several years, the Internal Revenue Service has taken 
an active role in reviewing various aspects of tax shelter investments. 
This involves a review of past, as well as present, positions with 
respect to arrangements which are packaged in the form of tax shelter 
investments to determine whether they meet the requirements to allow 
the special tax benefits. 

A summary of the various rulings published by the IRS in the 
general area of tax shelter investments appears below. 

Advance Rulings for Partnership Tax Treatment 

Under present law, if the purpose of a transaction is tax avoidance, 
the transaction may be set aside for Federal tax purposes, with the 
result that the taxpayer will not receive the deductions resulting from 
the transaction to Avhich he Avould otherwise be entitled. See Court 
Holding Co. v. Commissioner., 324 U.S. 331 (1945). As a result, the 
Service generally will not issue a ruling letter with respect to any 
transaction where there is a serious question as to whether or not the 
principal purpose of the transaction is tax avoidance. 

In recent years the Service has issued Revenue Procedures setting 
forth certain conditions that must be met before the Service will issue 
a favorable ruling that a limited partnership will be treated as a part- 
nership for Federal tax purposes. 

In Rev. Proc. 74-17, 1974-1 C.B. 438 (TIR-1290, issued May 3, 
1974), the IRS set forth certain guidelines which it will apply in 
determining whether the formation of a limited partnership is for the 
principal purpose of reducing Federal taxes. If the requirements of 
Rev. Proc. 74-17 are not satisfied, no ruling letter will be issued. How- 
ever, the taxpayer is still free to argue (with an Internal Revenue 
agent, or before a court) that he is entitled to the deductions claimed 
in connection with the partnership. 

The IRS guidelines contained in Rev. Proc. 74-17 are as follows : 

(1) All of the general partners, in the aggregate, must have at least a 
one percent interest in each material item of partnership income, gain, 
loss, deduction or credit. 

(2) The aggregate deduction of the limited partners during the 
first two years of the partnership's operations cannot exceed the 
amount of the equity investment in the partnership. 

(3) No creditor who makes a nonrecourse loan to the partnership 
may acnuire, as a result of making the loan, anv direct or indirect 
interest in the profits, capital, or property of the limited partnership, 
other than as a secured creditor. 

Nonrecourse Loans 
In many situations, so-called "nonrecourse loans" bear a striking 
resemblance to, and in substance ai-e, equity contributions to the lim- 
ited partnership. In 1972, the Service issued two Revenue Rulings 
pertainino- to certain allesjed to be nonrecourse loans. A^Hiile both 
rulings dealt with and had particular aj^plication to limited partner- 



19 

ships engaged in gas and oil exploration, they are susceptible to a 
much broader application. 

In Rev. Rul. 72-135, 1972-1 C.B. 200, the Service ruled that an 
alleged nonrecourse loan from the general partner to a limited part- 
ner, or from the general partner to the partnership, would be treated 
as a contribution to the capital of the partnership by the general part- 
ner, and not as a loan, thereby precluding an increase in the bases of 
the limited partners' partnership interests with respect to any portion 
of such loans. In Rev. Rul. 72-350, 1972-2 C.B. 394, the Service 
ruled that a nonrecourse loan by a nonpartner to the limited part- 
nership, which was secured by a highly speculative and relatively low 
value property of the partnersliip. and which was convertible into an 
equity interest in the partnership's profits, did not constitute a bona 
fide loan, but was, in realitv, an equitv contribution to the partnership. 

In recently issued Rev. Proc. 74-17, the Service stated that it would 
not issue an advance ruling granting partnership status to a limited 
partnership where a creditor had made a nonrecourse loan to the part- 
nership and could acquire at any time, as a result of such loan, a direct 
or indirect interest, other than as a secured creditor, in any profits, 
capital or property of the partnership. 

Prepaid Interest 
Prepaid interest deductions are frequently claimed in tax shelter 
ventures. In 1968, the IRS issued Rev. Rul. 69-643, 1968-2 C.B. 76, 
which, using distortion of income as its main criterion, in effect, re- 
stricted prepayment of interest to the taxable year succeeding the year 
of prepayment. Moreover, the IRS cautioned that even with respect to 
those prepayments for the year succeeding the year of prepayment 
(i.e., for a period not more than 12 months beyond payment), mate- 
rial distortions of income could result in a disallowance of all or part 
of such prepayment. Recently, the position taken by the Service has 
been sustained, for the most part, in two cases, Sandor, 62 T.C. 469 
(1974). (prepayment of five years' interest), and Burck, 63 T.C. 556, 
(1975). (prepayment of one year's interest). 

Preiiaid Feed Deduction 
One of the major tax shelter deductions in the farming area has 
derived from prepavments at the end of the year for livestock feed to 
be consumed in a following taxable year. Concerned with the possible 
resulting distortion of income and whether such prepayments have a 
bona fide business purpose, the Service issued Rev. Rul. 75-152, 1975-17 
I.R.B. 15. Tliis ruling requires that (for a current year's deduction to 
be available) the prepayment be for the purchase of feed, rather than 
a mere deposit ; that it be for a business purpose and not merely for 
tax avoidance ; and that the deduction in the vear of prepayment not 
result in a material distortion of income. (It should be noted that 
those actively engaged in farming as their principal occupation fre- 
quently claim deductions for prepaid feed expenses.) 

Syndication and Orga.vization Fees 
Until recently, it had been common practice for limited partner- 
ships to deduct the payments made to the general partner for the serv- 
ices he rendered in connection with the svndication and organization 



20 

of the limited partnership. However, in Rev. Rul. 75-214 (1975-23 
I.R.B. 9), the Service ruled that such payments to general partners 
for services rendered in organizing and syndicating a partnership 
constituted capital expenditures which were not currently deductible. 

Eqidpment Leasing 

The tax shelter expectations of the parties to a lease of personal 
property Avhich, in most cases, is leveraged ^ are dependent upon the 
transaction being treated as a lease and not as some form of sale of the 
property involved. In the mid-1950's, the Service issued a number of 
rulings, and recently issued Revenue Procedure 75-21 (I.R.B. 1975- 
18, 15) setting forth the criteria to distinguish between what is a bona 
fide lease and a sale of property. Under these Rulings and Revenue 

The tax shelter expectations of the parties to a lease of personal 
Procedure, the terms of the lease agreement in question will be closely 
scrutinized and, if the economic substance is such that it more closely 
resembles a sale of property, as opposed to a lease, lease treatment, and 
the resulting tax advantages flowing therefrom, will not be accorded 
the parties to transaction. One of the main requirements to be met for 
the lessor to be treated as such, is that he must maintain a minimal 
and unconditional investment in the property in question. 

Intangible drillivg and develofifnent costs 

One of the basic tax deductions commonly used in oil and gas tax 
shelters is that for intangible drilling costs which, essentially, consists 
of amounts paid for labor, fuel, repairs, hauling, and supplies, etc. 
which occur in connection with the drilling of wells for the production 
of oil or gas. To the extent an item (e.g., pipe) has a salvage value, it 
does not qualify as an intangible drilling cost. The deduction of in- 
tangible drilling costs is elective with the taxpayer. 

In Rev. Rul. 68-139, 1968-1 C.B. 311, the IRS ruled that a limited 
partnership may earmark a limited partner's contribution to expendi- 
tures for intangible drilling costs, thereby allowing the allocation of 
the entire deduction to the limited partners (if the principal purpose 
of such allocation is not the avoidance of Federal taxes). 

In another ruling in this area, Rev. Rul. 71-252, 1971-1 C.B. 146, 
the Service has ruled that a deduction may be claimed for intangible 
drilling costs in the year paid, even though the drilling was performed 
during the following year, so long as such payments are required to 
be made under the drilling contract in question. ^ 

^ A "leveraged lease", recently having become a very popular financing and tax 
shelter device, typically involves three parties — the lessor, the lessee and the 
lender. It may be defined as a net lease of property for a substantial part of the 
useful life of such property, where a substantial part of the purchase price of 
such property is obtained thi-ough borrowing by the lessor, and where the rents 
paid hy the lessee are at least sufficient to amortize the lessor's borrowings. It is 
the substantial borrowing of the lessor, which usually is on a nonrecourse basis, 
whicli adds the "leverage" aspect to what other\Adse might be described as a 
"straight lease" transaction. The lender does take a security interest in the 
leased property and. as a matter of practice, looks to the credit worthiness of 
the lessee before making the loan. 

* See also Rev. Rul. 71-579, 1971-2 C.B. 225. 



21 

Current Positions of the Securities and Exchange Commission 
With Regard to Tax Shelter Investments 

The Securities and Exchange Commission ("SEC") has also taken 
an active role over the last several years in reviewing various aspects 
of tax shelter investments. Under the full disclosure requirements of 
the Securities Act of 1933 and the Securities Exchange Act of 1934, 
any material risks of adverse tax consequences must be fairly disclosed 
to prospective investors. Mindful that certain tax shelter benefits some- 
times constitute a substantial investment inducement and that certain 
issues of Federal tax law relating to tax shelters are as yet unsettled, 
the SEC requires certain disclosures regarding various aspects of tax 
shelters which may involve material risks of adverse tax consequences. 
Although only public offerings of securities must be registered with 
the SEC, the anti-fraud provisions of Federal securities laws apply to 
private and intrastate as well as public offerings. Consequently, while 
SEC disclosure requirements and policies have direct application only 
to public offerings, they also have indirect application to intrastate 
and private offerings. 

Qualification for partnership tax treatment 
In tax shelters, it is of critical importance that a limited partner- 
ship be treated as a partnership for tax purposes in order that the tax 
benefits generated by the partnership pass through to, and may be 
used bv. the limited partners. In manv instances, a limited partner- 
ship will not apply for an advance ruling that it has partnership tax 
status, but, instead, obtains an opinion of counsel to this effect. In 
these cases, the SEC requires a disclosure that no advance ruling was 
obtained, that the opinion of counsel is not binding on the IRS, and 
that, in the event of the reclassification of the limited partnership as 
an association taxable as a corporation, investors would lose the pass- 
through of tax benefits. 

Nonrecourse loans 
Generally, the SEC suggests appropriate risk disclosures as to the 
possible applicability of Rev. Ruls. 72-135 1972-1 C.B. 200 and 72-350 
1972-2 C.B. 394 in which the Service held that certain "nonrecourse 
loans" were, in substance, equity contributions to the oil and gas ex- 
ploration limited partnership involved. (See Internal Revenue Serv- 
ice — Nonrecourse Loans, above). Less emphasis is placed on such 
disclosures in real estate partnerships than in exploratory oil and gas 
drilling partnerships. 

Prepaid interest 
"With respect to a real estate limited partnership which deducts a 
large interest prepayment in its first year of operation and which has 
little or no income in such year, the SEC suggests a disclosure to the 
effect that the IRS may disallow the prepayment on the ground that it 
constitutes a distortion of the partnership's income and that the IRS 
would allocate the deduction for such prepayment ratably over the 
term of the loan. 



22 

Prepaid feed deduction 
In cattle-feeding partnership registration statements, the SEC re- 
quires a cover-page disclosure to the effect that there is a substantial 
risk that the IRS will disallow a deduction, and thus reduce or elimi- 
nate contemplated tax benefits, for payments for cattle feed which 
will be consumed in a taxable year folloA^ing that of payment. 

Intangible drilling and development costs 
Currently, the SEC does not require extensive risk disclosures with 
respect to prepayments of intangible drilling costs. 

Management fees 
Many limited partnerships make rather sizeable payments of what 
is referred to as "management fees" to general partners of the partner- 
ship. These fees, wliich often are deducted in the 3^ear of payment by 
the partnership, many times relate to services in organizing the part- 
nership and services that will be rendered in taxable years following 
the year of payment. As to the deductibilty of these fees, the SEC 
suggests risk disclosures to the effect that they will not be deductible if 
they constitute a capital expenditure or if they represent unreasonable 
compensation. 

Partnership allocations 
While section 704 of the Internal Revenue Code provides the flexi- 
bility for allocating among partners various partnership items of 
income, deductions and credits, these allocations may be disregarded 
under existing law if their principal purpose is the avoidance or eva- 
sion of income taxes. With respect to these special allocations, including 
retroactive allocations to new partners, the SEC requires an opinion 
of counsel that they do not have tax avoidance as their principal pur- 
pose and/or a disclosure to the effect that the special allocation may 
be disregarded upon an IRS audit of the partnership's returns. 



2. GENERAL APPROACHES TO REVISION 

Should the committee decide to deal directly or indirectly with tax 
shelter investments there are a number of possible alternative ap- 
proaches that might be utilized. If it is determined that certain incen- 
tives are no longer desirable or that the tax benefits from the pref- 
erences are greater than they need be, those provisions could be revised 
directly ; that is, the particular provisions could be eliminated or cut 
back to some extent. 

If it is determined that certain incentives should be continued but 
that the tax benefits involved should not be available to be used to off- 
set income unrelated to that particular activity, the tax benefits could 
be limited to the income from that particular activity, thus, not allow- 
ing excess deductions to be used to shelter other income. This is ba- 
sically the LAL approach (limitation on artificial accounting losses) 
which was proposed by the Administration and essentially adopted in 
the House bill reflects this approach. 

A third approach is to deal with tax shelter investments through 
the minimum tax. This is the approach that the Congress took in 1969 
when it enacted a minimum tax to make sure that taxpayers paid at 
least some tax on those specified tax preferences that were determined 
appropriate to continue for the desired economic or social purpose. 

As indicated above, the House dealt with tax shelters essentially in 
the LAL provisions. However, the House bill also includes a number 
of other provisions dealing with related aspects of tax shelters, such 
as the use of nonrecourse loans and the conversion of ordinary income 
into capital gains. These provisions of the House bill are briefly de- 
scribed at the end of this pamphlet. (The House bill also modified and 
expanded the application of the existing minimum tax. This topic will 
be discussed in a subsequent pamphlet.) A subsequent tax shelter op- 
tions pamphlet will focus in a more comprehensive fashion on the 
various methods by which the committee might deal with the question 
of tax shelters. 

(23) 



3. REAL ESTATE 

General 

The real estate industry is a capital intensive industry. The acquisi- 
tion or construction of apartment buildings, shoppino; centers, com- 
mercial office buildings, hotels and motels, etc., generally requires the 
commitment of large amounts of capital over a relatively long period 
of time. To provide this capital, a number of investment vehicles have 
been utilized which allow investors to pool their financial resources. 
This pooling of investment is commonly referred to as "real estate 
syndication" and may be set up in any one of a number of legal forms, 
such as a joint venture, a partnership, a real estate investment trust, 
or a corporation. These various legal forms differ with respect to the 
investor's right of control and participation in management, rights 
of survivorship, personal liability, tax treatment, etc. This section of 
the pamphlet describes those forms of real estate investment which 
tend to be used most frequently to produce a "tax shelter" and analyzes 
the various elements which, taken together, made up a real estate tax 
shelter. 

A real estate investment decision generally involves an evaluation, 
of the potential risks and a comparison of those risks with the overall 
rate of return, including the potential cash flow, the potential for ap- 
preciation, and the potential tax benefits. The various provisions that 
provide tax benefits for real estate include the deduction for accelerated 
depreciation, the deduction for interest and taxes during the construc- 
tion period, the deduction for prepaid interest, the rules of partnership 
taxation (including the determination of a partner's basis, especially 
the treatment of nonrecourse loans, and the allocation of income and 
los?es among the partners) , and capital gain treatment upon the sale 
of the property. 

In general, a real estate tax shelter is an investment in which a 
significant portion of the investor's return is derived from the realiza- 
tion of tax savings on other income as well as the receipt of tax-free 
cash flow from the investment itself. The tax savings are principally 
achieved by allowing current deductions, for costs, which, in the opin- 
ion of some, are properly attributable to later years. For example, dur- 
ing the construction period the interest paid on the construction loan 
and the real estate taxes are immediately deducted even though there is 
no income from the property. Later, after the building is completed, 
deductions for accelerated depreciation are permitted which, for a pe- 
riod of years, are generally greater than the net rental income before 
depreciation. These deductions (construction period costs and accele- 
rated depreciation) combine to generate losses which can be used to 

(25) 



26 I 

offset income from other sources, such as salary and dividends. In 
effect, taxpayer is allo\ved to defer or postpone the payment of tax on i 
current income, either by offsetting current income with loss deduc- ; 
tions attributable to real estate or by receiving a tax-free cash flow 
from the real estate project, or both. 

The entity most commonly used to create real estate tax shelters 
and produce the maximum tax benefits for an individual investor '] 
is the limited partnership. Typically, a real estate venture is syn- | 
dicated as a limited partnership with the builder-entreprenuer as 
the general partner and the investors as limited partners. Unlike a 
corporation, the partnership itself is not subject to tax, but serves as \ 
a conduit through which the tax consequences of a particular project , 
are passed to the individual partners. Thus, to the extent that the 
partnership incurs losses during a particular taxable year, these losses 
are allocated to and become the individual losses of the various \ 
partners. 

A partner, including a limited partner, can deduct these losses only 
to the extent of the basis in his partnership interest. However, a limited 
partner's basis includes his share of those libalities of the partnership 
for which no partner is personally liable ("nonrecourse liability"). 
This rule relating to nonrecourse debt is extremely important in real 
estate since such debt financing (leverage) increases the tax benefits ! 
to the limited partners and permits them to deduct losses which exceed 
the amount thev have at risk. 

In addition, this form of business ownership has several other ad- \ 
vantages. For example, one of the important characteristics of real { 
estate syndication is the extent to which mortgage financing can be . 
obtained to acquire property. It is often possible for a syndication to ' 
arrange financing for as much as 90 j^ercent of the purchase price. The ' 
remaining 10 percent (or equity) of the purchase price can be raised by i 
sellinc: small shares or units in a partnership to numerous investors ' 
who become limited partners. Through the use of borrowing by the 
partnership, the risk of loss to the individual limited partners is mini- 
mized, since the limited partners are passive investors and their lia- \ 
bility for the debts or claims against the partnership is limited to their ■ 
investments in the partnership. ' 

Types of Shelter Deductions 

In the case of a real estate tax shelter, two types of accelerated de- 
ductions are principally utilized to generate losses: the deduction for 
accelerated depreciation and tlie deduction for construction period 
interest and taxes. In certain cases, prepaid interest may also be uti- ' 
lized, but the availability of a deduction for prepaid interest is not 
peculiar to the real estate tax shelter. Accelerated depre<?iation is | 
generally treated as an item of tax preference under the minimum tax, 
but construction period costs and prepaid interest deductions are not ' 
so treated. 



27 

In addition to generating tax losses, these deductions may not sub- 
sequently be subject to recapture, thus resulting in the conversion of 
ordinary income into capital gain.^ 

Depreciation 

Before 1946 depreciable real estate buildings generally were depre- 
ciaited under the straight line method for income tax purposes (that is, 
a depreciation deduction of an equal pro rata amount over the useful 
life of the property) . In 1946 administrative practices began to permit 
the depreciation of real estate on the 150 percent declining balance 
method, which had previously been available only for tangible per- 
sonal property, such as machinery or equipment. Under the 1954 code, 
both new real property and new tangible personal property could be 
depreciated under either the double declining balance method or the 
sum of the years-digits method of depreciation by the first owner.- A 
later owner was permitted to use the 150 percent declining balance 
method.^ 

The Tax Reform Act of 1969 limited the extent to which accelerated 
depreciation would be allowed with respect to real property. Under 
this Act, the use of accelerated methods of depreciation depends upon 
the class of property involved. A description of these classes of i>rop- 
erty and the methods available for each class is provided below follow- 
ing a brief analysis of the depreciation methods generally. 

It is important to note that depreciation is allowable with respect 
to the entire cost basis in the depreciable portion of the property and 
not merely with respect to the taxpayer's equity. Thus, if an apartment 
building is purchased at a cost of $120,000 ($20,000 for the land and 
$100,000 for the building) depreciation may be taken on the entire 
$100,000 cost of the apartment building even if the entire property is 
purchased for $20,000 cash and a $100,000 mortgage. The total depre- 
ciation taken within the first 4 or 5 years is likely to exceed the owner's 
entire net equity. (See table below.) 

The following summarizes the firet year, first 5-year, and first 10- 
year depreciation deduction as a percentage of a building's cost with 
25- and 40-year lives under the four major alternative depreciation 
formulas : 



^ Although the depreciation recapture rules are designed to prevent conversion 
by taxing certain gain from sales as ordinary income rather than capital gain, 
they do not fully recapture accelerated depreciation in all cases. 

" The code also permits the use by the first owner of "any other consistent 
method productive of an annual allowance which, when added to all allowances 
for the period commencing Avith the taxpayer's use of the property and including 
the taxable year, does not, during the first two-thirds of the useful life of the 
property, exceed the total of such allowances which would have been used 
had such allowances been computed under the [double declining balance] 
methods * * *." 

' The second owner may be able to approximate, at l^o times declining balance, 
the depreciation deductions available to the first owner, since the second owner 
often can depreciate over a shorter useful life than the first omier. The other 
benefits described below (depreciation calculated upon total basis, little recap- 
ture, and generally capital gains at disposition) are available to second and sub- 
sequent owners as well as to the first owner. 



28 

[In percent] 



Straight 
line * 



200-percent 
declining 
balance ^ 



life 



Sum-of-the- 

years 

digits ^ 



150-percent 
declining 
balance ^ 



25-yr 40-yr 25-yr 40-yr 25-yr 40-yr 25-yr 40-yr 



life 



life 



life 



life 



life 



life 



life 



Year 1 4 2.5 8.0 5.0 7.7 4.9 6.0 3.75 

1st 5-year 

total 20 12.5 34.1 22.6 35.4 23.2 26.6 17.40 

1st 10-year 

total 40 25.0 56.6 40.1 63.1 43.3 46.1 31.80 



The use of these different methods depends, as a result of the Tax 
Reform Act of 1969, upon whether the property is residential rental 
property, non-residential property, or low income residential prop- 
erty. In addition, in the case of residential and non-residential 
property, the allowable method also depends upon whether the 
property is new or used. 

In general, residential rental property includes single and multiple 
family housing, apartments, and similar structures which are used 
to provide living accommodations on a rental basis. A building or other 
structure will qualify as residential rental property if 80 percent or 
more of the gross rental income from the building or structure is rental 
income from dwelling units. Hotels, motels, inns, or other similar 
establishments are not treated as dwelling units if more than one-half 
of the units are used on a transient basis. 

With respect to new residential property (the original use of which 
commences with the taxpayer) , both the 200 percent declining balance 
method and the sum of the years digits method are allowed. (The sum 
of the years digits method is not allowed for any other class of real 
property. ) Residential property which is itsecl property can be depre- 
ciated at a 125 percent declining balance rate if it has a remaining 

* The straight-line method of depreciation results in an equal annual expense 
charge for depreciation over an asset's useful life. For purposes of computation, 
the straight-line rate is determined by a fraction, the numerator of which is one 
and the denominator of which is the estimated useful life of the asset. 

^The 200-percent declining balance method of depreciation, more commonly 
referred to as double-declining balance, allows a rate equal to twice the straight- 
line rate. In either case, the declining balance rate is applied to the unrecovered 
cost, i.e., cost less accumulated depreciation for prior taxable .vears. Since the 
depreciation base is reduced to reflect prior depreciation, the amount claimed as 
depreciation is greater in earlier years and declines in each succeeding year of an 
asset's useful life. 

"The sum of the years' digits method of depreciation is computed using a frac- 
tion the numerator of which is the years' digits in inverse order and the denomi- 
nator of which is the sum of the number of years. For example, if an asset has 
an estimated useful life of 10 years, the denominator is the sum of one plus 2 
plus 3, etc., plus 10, or 55. The numerator would be 10 in the first year, 9 in the 
second year, etc. Thus, in the first year, the fraction would be 10/55. in the sec- 
ond year 9/55, etc. As in the case of the declining balance method, the annual 
depreciation is greater in earlier years and declines in each succeeding year of an 
asset's useful life. 

'' The 150-percent declining balance method of depreciation allows a rate equal 
to 1.5 times the straight-line rate. 



29 

life of 20 years when acquired. If used residential property has a 
remaining life of less than 20 years, only straight line depreciation is 
permitted.^ 

The second class of property is non-residential rental property 
which includes buildings or other structures that are not used to pro- 
vide living accommodations, such as commercial office buildings, indus- 
trial buildings, shopping centers, etc. 

In the case of new non-residential property, depreciation under the 
declining balance method is limited to a rate which does not exceed 
150 percent of the rate determined under the straight-line method.^ 

In addition to the rules relating to the two classes of property men- 
tioned above, special amortization rules are provided for expenditures 
to rehabilitate low income rental housing (sec. 167 (k) of the code). 
Low income rental housing includes buildings or other structures 
that are used to provide living accommodations for families and indi- 
viduals of low or moderate income. An individual or family is con- 
sidered to be of low or moderate income only if their adjusted income 
does not exceed 90 percent of the income limits described by the Secre- 
tary of HUD for occupants of projects financed with certain mort- 
gages insured by the Federal Government. The level of eligible in- 
come varies according to geographical area.^° 

Under the special amortization rules for this low or moderate in- 
come property, taxpayers can elect to compute depreciation on certain 
rehabilitation expenditures under the straight-line method over a pe- 
riod of 60 months if the additions or improvements have a useful life 
of 5 years or more. Only the aggregate rehabilitation expenditures as 
to any housing which do not exceed $15,000 per dwelling unit qualify 
for the 60-month depreciation. In addition, for the 60-month deprecia- 
tion to be available, the sum of the rehabilitation expenditures for two 
consecutive taxable years — including the taxable year — must exceed 
$3,000 per dwelling unit. 

Interest and taxes during construction period 
Under present law. amounts paid for interest and taxes during 
the construction of real property are allowable as current deduc- 
tions except to the extent the taxpayer elects to capitalize these items 
as carrying charges." If an election is made to capitalize these items, 
the amount capitalized will be amortized over the useful life of the 



* Other accelerated methods may be used for residential property if the depre- 
ciation allowance under these methods during the first two-thirds of the useful 
life does not exceed the depreciation allowance under the applicable declining 
balance. 

" Other accelerated methods may be also used for new non-residential property 
if the depreciation allowance under these methods during the first two-thirds of 
the useful life does not exceed the depreciation allowable under the applicable 
declining balance method. No accelerated depreciation is allowable with respect 
to u^ed non-residential real property. 

'" The current level of eligible income for a family of four is .$15,400 in Wash- 
ington. D.C.. $13,700 in Chicago, and $11,900 in Los Angeles. Thus, 90 percent 
of these limits are $13,860. $12,330, and $10,710 respectively. 

^'^ Interest and taxes paid or accrued during the construction period is de- 
ductible under the provisions dealing with the deductibility of interest and 
taxes in general (sec. 163 or 164, respectively). No deduction is currently allow- 
able if the taxpayer elects to capitalize these expenses (sec. 166). 



30 

building. The deduction for taxes (sec. 164) includes sales and real 
estate taxes paid or accrued on real or personal property during the 
construction period. The deduction for interest during the construction 
period includes amounts designated as "points" or loan processing fees 
so long as these fees are paid by the borrower prior to the receipt of the 
loan funds and are not paid for specific services.^^ (Generally, construc- 
tion period interest is not presently treated as investment interest for 
purposes of the limitation on investment interest (sec. 163(d)) or 
treated as a tax preference for purposes of the minimum tax in com- 
puting the preference for excess investment interest for purposes of 
the minimum tax or tax preferences. 

Recapture of accelerated depreciation 

Under present law, net gains on the sale of real property used in 
a trade or business (with certain exceptions) are taxed as capital 
gains, and losses are generally treated as ordinary losses. However, 
gain on the sale of buildings is generally "recaptured" and taxed as 
ordinary income rather than capital gain to the extent that the gains 
represent accelerated depreciation taken in excess of the amount that 
would be allowed under the straight-line method of depreciation. 

The provisions relating to depreciation recapture were first enacted 
in 1962 to prevent deductions for depreciation from converting 
ordinary income into capital gain. In general, the 1962 provision 
(sec. 1245 of the code) provided that gain on a sale of most tan- 
gible personal property would be taxed as ordinary income to the 
extent of all depreciation taken on the property after December 31, 
1962. In 1964, the recapture rules were extended to real property 
(buildings) to provide in general that gain or a sale would be taxed 
as ordinary income to the extent of the depreciation ( in most cases only 
the accelerated depreciation) taken on that property after Decem- 
ber 31, 1963. This provision (sec. 1250 of the code), however, had a 
gradual phase-out of the recapture rules. If the property had not been 
held for more than 12 months, all of the depreciation was recaptured. 
However, if the property had been held over 12 months, only the excess 
depreciation over straight-line was recaptured and the amount re- 
captured was reduced after an initial 20-month holding period at the 
rate of one percent per month. Thus, after 120 months (10 years) 
there was no recapture of any depreciation. 

In the Tax Reform Act of 1969, the recapture rules were further 
modified as to post-1969 depreciation on real propei-ty. Under the 
Act, in the case of residential real property and property with respect 
to which the rapid depreciation for rehabilitation expenditures has 
been allowed, post-1969 depreciation in excess of straight-line is fully 
recaptured at ordinary income rates if the property has been held 
for more than 12 months " but less than 100 months (8 years and 4 
months). For each month the property is held over 100 months, there 
is a one percent per month reduction in the amount of post-1969 depre- 
ciation that is recaptured. Thus, there will be no recapture of any 

"See Rev. Riil. 61^643 (C.B. 196R-2. 76), Rev. Rul. 69^188 (C.B. 1969-1, 54) 
and Rev. Rul. 69-582 (C.B. 1969-2, 29). 

" There was no change in the rule providing for recapture of all depreciation 
(including straight-line) if the property is not held for more than 12 months. 



31 

depreciation if the property is held for 200 months (16 years and 8 
months) . 

In the case of non-residential real property, all post-1969 depreci- 
ation in excess of straight-line depreciation is recaptured (to the 
extent there is gain) regardless of the length of time the property is 
held. 

In addition, in the case of certain Federal, State, and locally assisted 
housing projects constructed, reconstructed, or acquired before Janu- 
ary 1, 1976, such as the FHA 221(d) (3) and the FHA 236 programs, 
the pre-1969 recapture rules on real property are retained." However, 
if the property is constructed, reconstructed, or acquired after Decem- 
ber 31, 1975, the regular post-1969 rules previously discussed above 
with respect to residential property will apply (i.e., a one percent 
reduction per month after 100 months). 

Leverage 
As noted previously, the amount of loss a partner may deduct is 
limited to the amount of his adjusted basis in his interest in the part- 
nership (sec. 704 (d) ) , which is reduced by the amount of any deducti- 
ble losses (sec. 705). Generally, the partner's basis in his partnership 
interest is the amount of his cash and other contributions to the part- 
nership (sec. 722). If a partner assumes liability for part of the part- 
nership debt, this also increases his basis. However, under the regula- 
tions, where the partnership incurs a debt and none of the partners 
have personal liability (a "nonrecourse" loan), then all of the part- 
ners, incUiding limited partners, are treated as though they shared 
the liability in proportion to their profits interest in the partnership 
(Eegs. § 1.752-1 (e)). 

Issues 

The material below sets forth some of the principal issues with re- 
spect to the use of tax shelter ventures in real estate and the principal 
tax deductions commonly utilized in such ventures. 

Accelerated DeyTeciation. — The allowance of deductions for accel- 
erated depreciation on real property has been criticized on the ground 
that the economic cost attributable to the exhaustion of the de- 
preciable portion of the property will rarely equal the amount claimed 
as a deduction during the earlier years of its useful life. In fact, the 
property may appreciate in value rather than depreciate. Moreover, 
it is pointed out by some that accelerated depreciation will frequently 
exceed the amount required to service a mortgage against the property 
during the early life of the property (yielding a positive cash flow from 
the property). 

Because of the present tax situation, when an investment is solicited 
in a real estate venture, it is argued that it has become common practice 

"That is, with respect to these projects, accelerated depreciation will be 
fully recaptured at ordinary income rates only if the property has been held for 
not more than 20 months. ( If the property is sold within 12 months, all of the 
depreciation is recaptured.) For each month the property is held over 20 months, 
there is a 1 percent per month reduction in the amount of accelerated depreciation 
recaptured. Thus, there will be no recapture if the property is held for a period 
of 120 months (10 years). 



32 

to promise a prospective investor substantial tax losses which can be 
used to decrease the tax on his income from other sources. 

Construction Period Costs. — Some argue that the allowance of a 
deduction for construction period interest and taxes is contrary to the 
fundamental accounting principle of matching income and expenses. 
Generally, a current expense is deductible in full in the taxable year 
paid or incurred because it is necessary to produce income and is 
usually consumed in the process. However, some expenditures are 
made prior to the receipt of income attributable to the expenditures 
and, it is argued that under the matching concept, these expenditures 
should be treated as a future expense when the income "resulting" 
from the expenditure is received and the original investment is grad- 
ually consumed. Alternatively, it is argued that the allowance of a de- 
duction for construction period interest should be deductible in the year 
paid, notwithstanding the fact that the building is in process and not 
yet placed in service, because the interest is a cost of financing and not 
a cost incurred to acquire the building; likewise, taxes paid during the 
construction period are period costs, not capital costs, because they do 
not add value to the underlying assets. 

In addition, when a building is sold, any realized gain may be eligi- 
ble for capital gains treatment to the extent accelerated depreciation is 
not recaptured as ordinary income. However, there is no recapture with 
respect to the construction period interest and taxes. 

Many argue that the provisions of present law providing incen- 
tives are essential to attract investment in an industry already suffer- 
ing from a shortage of capital. Without these incentives, they urge, the 
capital shortage problem will be severely aggravated. -■ 



4. FARM OPERATIONS 

General 

Farm operations generally involve raising animals and plants to 
provide food and fiber in the United States and abroad. As with other 
businesses, most taxpayers are engaged in farming operations prin- 
cipally in order to derive economic profits from them. Some taxpayers, 
however, acquire farms or ownership interests in farm activities be- 
cause several special tax rules that apply to farm operations can be 
used to shelter income earned in other economic activities. The major 
tax advantages are a deferral of tax payments for one or more years, 
deferral until the taxpayer's taxable income falls to a lower marginal 
tax bracket, or conversion of the income (and the tax rate) from 
ordinary income to capital gain. 

Tax deferral usually results from the current deduction of costs 
which are associated with the income which will not be reported until 
a later taxable year. Examples of costs which can be deducted before 
the related income is recognized are feed costs for animals which will 
not be sold until the next taxable year and costs of developing breed- 
ing animals, vineyards, and orchards. 

Conversion occurs where capital and development costs have been 
deducted in the year incurred against ordinary income from other 
sources (instead of being capitalized and depreciated) and then in a 
later year the fully developed farm operation is sold at a capital gain. 

Farm operations vary in size from small family farms to large 
multi-unit farms. The types of ownership in which taxpayers engage 
in farming vary from sole proprietorships, family partnerships and 
family corporations to large corporations and nationally syndicated 
limited partnerships with passive investors. 

Farm operations are governed by special tax rules, many of which 
confer tax benefits on farming activities and on persons who engage in 
farming. Some of these special rules (such as permission to utilize 
the cash method of accounting) reflect an historical intent to sim- 
plify recordkeeping for farmers; other rules provide incentives for 
farmers to engage in land improvements and other activities. Still 
other farm rules are intended to correct abuses of the special farm 
tax rules. These corrective rules have been added (particularly in 
the Tax Reform Act of 1969) because in recent years high-bracket tax- 
payers such as business executives, doctors, lawyers, entertainers, ath- 
letes, and other investors whose principal occupations are outside of 
farming, have invested in farming operations that generate farm "tax 
losses'' which they use to shelter nonfarm income.^ 

^ Under present law, the special tax rules available to farmers can be utilized 
by both full-time farmers and by high-bracket taxpayers who participate in farm- 
ing as a sideline. Part-time farmers are entitled to use the special farm rules even 
if they are absentee owners who pay agents to operate their farming activities 
and regard their own participation (such as being limited partners in a nation- 
wide syndicate) as a completely passive investment. 

(33) 



34 

Where individual investors with large nonfarm incomes begin 
farming on a part-time basis or become passive investors in farm 
activities, certain deductions, which are currently allowed under the 
special farm rules, become particularly attractive. These deductions, 
which are deliberately sought by nonfarmer investors, are used to re- 
duce their taxes on income from other sources. Furthermore, when the 
property stops providing tax losses and starts producing taxable in- 
come, many investors in farm syndicates dispose of their investments. 

Like the outside investor, many "full-time" farmers or ranchers 
(that is, those individuals whose principal occupations are farming) 
also have other sources of income (from investments, from nonfarm 
employment or from nonfarm businesses) and can also utilize farm 
"tax losses" to reduce their taxes on their nonfarm income. 

Types of Shelter Deductions 

Use of the cash method without inventories 

Taxpayers engaged in farming may report their income and ex- 
penses from farm operations on the cash method of accounting, with- 
out accumulating inventory costs. Farmers may also deduct the cost 
of seeds and young plants purchased in one year which will be sold as 
farm products in a later year.- This rule contrasts with the tax rules 
which govern nonfarm taxpayers engaged in the business of selling 
products, who must report their income using the accrual method of 
accounting and must accumulate their production costs in inventory 
until the product is sold.^ 

The special inventory exception for farmers was adopted by ad- 
ministrative regulation more than fifty years ago. The primary justifi- 
cation for this exception was the relative simplicity of the cash method 
of accounting which, for example, eliminates the need to identify 
specific costs incurred in raising particular crops or animals. 

^ However, a farmer may not deduct the purchase price of livestock, such as 
cattle, which he intends to fatten for sale as beef. 

^ Under the cash method of accounting, all items which constitute gross in- 
come are reported in the taxable year in which actually or constructively re- 
ceived, and expenses are deducted in the taxable year in which they are actu- 
ally paid. The primary advantage of the cash method is that it generally re- 
quires a minimum of recordkeeping; however it does not match income with 
related expenses. 

A primary goal of the accrual method of accounting is a matching of income 
and expenses. Under this method, income is included for the taxable year when 
all the events have occurred which fix the right to receive such income and the 
amount can be determined wath reasonable accuracy. Under such a method, de- 
dutions are allowable for the taxable year in which all the events have occurred 
which establish the fact of the liability giving rise to the expense and the 
amount can be determined with reasonable accuracy. Also under the accrual 
method where the manufacture or purchase of items which are to be sold is an 
income-producing factor, inventories must be kept and the costs of producing 
the merchandise must be accumulated in inventory (rather than deducted 
when incurred). These costs may be deducted onlv in the vear the merchandise 
is sold. Regs. § 1.446-1 (a) (4) and (c). 

Use of the cash method without inventories gives a taxpayer the opportunity 
to control the timing of deductions to a much greater extent than does the accru- 
al method. 



35 

In cases where inventory costs are deducted in a year earlier than the 
year in which the related income is received, such accelerated deduc- 
tions create a '"loss" which is used to oliset a taxpayer's other income. 
When the income related to these accelerated deductions is realized 
in a later year, it will be in a greater amount than if the accelerated 
deductions had been deferred and matched against the income. The 
net eli'ect of the acceleration of these deductions is the deferral of 
taxes on the taxpayer's other income. 

Current deduction for development costs of business assets 
The Treasury has long permitted farmers to deduct currently many 
of the costs of raising or growing farm assets (such as costs related 
to breeding animals, orchards and vineyards) which are held for the 
production of income. In similar nonf arming businesses (such as man- 
ufacturing), these costs generally are treated as capital expenditures 
and are depreciated over their useful lives.* Typically, the development 
costs of certain farm assets can be expensed. These assets are used in 
a taxpayer's business and may eventually be sold at a gain which is 
taxed at the lower capital gain tax rate. Since development costs can 
be deducted before the income is realized from the sale of livestock 
or crops, the development costs may offset a farm investor's income 
from other sources such as salaries, interest, professional fees, etc. 

Current deduction of certain land inrvproveraent expenses 
Certain provisions of present law allow specific types of capital im- 
provements to farmland to be deducted when the taxpayer pays them. 
These costs include soil or water conservation expenditures (sec. 175), 
fertilizer costs (sec. 180), and land clearing expenses (sec. 182). Simi- 
lar capital expenditures in a nonf arm business would be added to the 
basis of the property and, since land is nondepreciable, could be recov- 
ered only out of the proceeds when the land is sold. 

Capital gain treatment for sales of assets developed through 
deductible expenditures 
Capital gain treatment is generally available on the sale of de- 
preciable assets used in farming (as well as on the sale of the under- 
lying farmland itself) , even though these assets or land may have been 
developed or improved by expenditures which were deducted against 
ordinary income.^ Thus, an investor or farmer can combine deductions 



* Thus, if a taxpayer builds a factory to be used in his manufacturing busi- 
ness, he is required to capitalize all the costs attributable to construction of the 
factory. Such costs will be recovered over the useful life of the building. 

There are certain exceptions to the requirement that costs attributable to busi- 
ness assets be capitalized. Thus, under section 174. a taxpayer may elect to deduct 
currently research and experimental expenditures. 

Of course, not all costs relating to development of farm assets are currently 
deductible. A farmer is required to capitalize costs of water wells, irrigation 
pipes and ditches, reservoirs, dams, roads, trucks, farm machinery, land and 
buildings. 

" Under section 1231, a taxpayer who sells property used in his trade or busi- 
ness obtains special tax treatment. All gains and losses from section 1231 prop- 
erty are aggregated for each taxable year and the gain, if any, is treated as 
capital gain. The loss, if any, is treated as an ordinary loss. Machinery, equip- 
ment, buildings, and land used by a taxpayer in his business are examples of 
section 1231 property. 



36 

from ordinary income for expenses of raising the livestock or develop- 
ing an orchard or vineyard with capital gain treatment when he sells 
the breeding animals, orchards, or vineyards. ( Capital gain treatment 
is not available to the extent that various recapture rules of present 
law are applicable.) ^ 

Accelerated depreciation 

After breeding animals, vineyards or orchards reach maturity and 
are held for the production of annual crops, farmers and farm in- 
vestors continue to receive tax benefits through deductions for accel- 
erated depreciation. For example, an investor or rancher can deduct 
his costs of raising breeding animals (but not the purchase price) 
and, after purchased animals reach maturity, he can use 200 percent 
declining balance depreciation on the purchase price of the animals 
which he originally purchased for the herd.^ 

Under the Asset Depreciation Range System (ADR), the depreci- 
able lives of farm assets are relatively short. For breeding or dairy 
cattle, the ADR range is 5.5-8.5 years. For breeding or work horses, 
the ADR class life is 8-12 years ; for breeding hogs, 2.5-3.5 years ; for 
breeding sheep and goats, 4-6 years; and for farm machinery and 
equipment, 8-12 years. 

Accelerated depreciation under a 150-percent declining balance 
method is also available for new farm buildings and for the costs of 
purchased vineyards and orchards. The capitalizable costs of vine- 
yards and orchards planted by the taxpayer may be depreciated on a 
200-percent declining balance method.^ 

The opportunity to claim accelerated depreciation on breeding ani- 
mals, orchards and other farm capital assets which have reached 
maturity means that farmers and farm investors can shelter not only 
their nonfarm income (by preproductive period cost deductions) but 
also part of their annual farm income from crop sales after the prop- 
erty reaches its productive period.'' 

* This capital gain benefit has been described in the staff's overview pamphlet 
on tax shelters as a "conversion" of the rate of tax on income offset by the early 
development deductions from ordinary income to capital gain. In effect, the 
taxpayer's nonfarm income which is initially sheltered by accelerated farm 
deductions is transformed into added capital value of the farm asset and taxed 
as part of that value when the farm capital assets (vineyard, breeding animal, 
farmland, etc.) are later sold. 

' If the rancher purchased cattle which had been used for breeding by a previous 
owner, the cattle can be depreciated on the 150 percent declining balance method. 
The offspring of purchased animals cannot be depreciated, since the owner is 
considered to have no cost basis in such animals. However, as indicated earlier, 
the c^st of raisins' such off.«*pring can be expensed. 

" Under the ADR system, the useful lives of farm buildings range from 20 to 30 
years. Although there are no ADR guidelines, taxpayers are currently using use- 
ful lives for fruit trees which vary from 15 to 30 years, depending on the type of 
trees and on different climate conditions. 

* The latter benefit is especially valuable to farm investors who are primarily 
interested in the appreciation in value of the underlying ranch land on which they 
maintain a breeding herd, vineyard or orchard. 

Many such taxpayers regard cattle as a cash crop which helps them carry the 
land by providing annual income to pay the underlying mortgage and real state 
taxes. Sheltering the cash flow from the property itself is as important to such 
investors as it is to the owners of a rental apartment house who use accelerated 
depreciation to shelter their annual rental income. 



37 

Investment credit 
The investment credit is available to farmers and farm investors for 
personal property used in farming. Livestock (except horses) held 
for the production of income, orchards and vineyards, and other tan- 
gible property such as fences, drain tiles, paved barnyards, water wells 
and storage facilities may qualify for the investment credit. 

Leverage 

A taxpayer who invests directly in a herd of feeder cattle, a vine- 
yard, or other farm property (including investments through agency 
relationships where the taxpayer signs a management contract with 
another person to operate the business on his behalf) can take advan- 
tage of leveraging to increase the amount of his deductions in a farm 
investment. Thus, if the taxpayer can borrow funds to pay for deduct- 
ible expenses he may deduct amounts in excess of his equity capital 
in the farm operation. 

Similarly, if an investor becomes a partner in a farming partner- 
shij), he may be able to deduct amounts in excess of his equity capital in 
the partnership if the partnership is financed in part by nonrecourse 
obligations." 

Tax Reform Act of 1969 

In the Tax Reform Act of 1969, Congress made several changes in 
the tax law that were designed to reduce the deferral and conversion 
benefits for farm investors. 

Recapture of certain farm losses 
Section 1251 requires a limited recapture as ordinary income (rather 
than capital gain) of previous farm tax losses whenever assets used 
in a farming business are sold or disposed of. If, in previous years, an 
individual taxpayer whose nonfarm income exceeclecl $50,000 in a year 
used the cash method of accounting and incurred a farm loss larger 
than $25,000 in the same year, the farm loss in excess of $25,000 must 
be recorded in an "excess deductions account" (EDA). Any gain that 
would otherwise be treated as capital gain on the later sale of farm 

^" The amount of loss a partner may deduct is limited to the amount of his 
adjusted basis in his interest in the partnership (sec. 704(d) ). 

Generally, the partner's basis in his partnership interest is the amount of his 
cash and other contributions to the partnership (sec. 722). If a partner assumes 
liability for part of the partnership debt, this also increases his basis. However, 
under the regulations where the partnership incurs a debt, and none of the part- 
ners has personal liability (the "nonrecourse" loan), then all the partners are 
treated as though they shared the liability in proportion to their profits interest 
in the partnership (Regs. § 1.752-1 (e) ). For example, if a partner invested 
$10,000 in a partnership, in return for a 10-percent profit interest, and the part- 
nership borrowed $100,000 in the form of a nonrecourse loan, the partner's basis 
in the partnership would be $20,000 ($10,000 of contributions to the partnership, 
plus 10 percent of the $100,000 nonrecourse loan to the partnership). 



38 

assets must be reported as ordinary income to the extent of the balance 
in the taxpayer's EDA account at that time." 

A farmer who elects to report his farm operations on an accrual 
method of accounting (and who thus uses inventories) is not subject 
to the EDA rules. 

This provision continues to allow a farm investor who uses the cash 
method of accounting to defer current taxes on his nonfarm income. 
It merely places a potential limit on the amount of ordinary nonfarm 
income which may be converted to capital gain in a future year. Thus, 
even where an EDA account must be maintained, this provision re- 
duces conversion benefits but does not affect the time value of deferring 
taxes on nonfarm income or (in the case of depreciation deductions) 
on annual farm crop income. 

Recapture of impro'veTnents to farm land 

Section 1252 recaptures amounts previously deducted as soil and 
water conservation and land clearing expenses if farmland is sold 
within 5 years after acquisition. If the land is held for a longer period, 
the amount recaptured is reduced by 20 percent for each year over 
5 years that the property is held. Thus, if the land is held more than 
10 years, there is no recapture. 

As in section 1251, this provision prevents (to some extent) farm 
investors from converting nonfarm income (previously offset by ordi- 
nary farm deductions) into capital gain when fannland is sold. This 
provision does not, however, prevent the initial deferral of taxes on 
nonfarm income. 

Capitalization of development costs of citrus and almond groves 

Section 278 contains a special rule which requires the capitalization 

of all amounts attributable to the planting, cultivating, maintaining 

or developing citrus groves incurred during the first four years after 

the grove was planted. 

This provision was enacted as a result of a concern that tax-shelter 
syndicates were engaging in citrus grove operations primarily to obtain 
current deductions for development expenses, and that the influx of 
these ventures into the citrus growing industry distorted the economics 
of the industry to the detriment of full-time citrus growers. For exam- 
ple, since a portion of the syndicate's return was in the form of tax 
benefits, it could accept lower prices for the sale of the crop than full- 
time farmers. 

The Revenue Act of 1971 extended this capitalization rule to almond 
groves. 



'^ It is immaterial what specific farm deductions produce a net farm loss. The 
EDA is a running account from year to year and is reduced by the amount of net 
farm income which the taxpayer may have in hiter years. 

Corporations (otlier tlian Subchapter S corporations) and trusts must establish 
an EDA account for the full amount of their farm losses regardless of size and 
regardless of the amount of their nonfarm income. A Subchapter S corporation 
is governed by the same dollar limitations that apply to individuals, except that 
the corporation must include in its nonfarm income the largest amount of non- 
farm income of any of its shareholders. 



39 

Lengthened holding periods for noninventory livestock 
The holding period for long term capital gain treatment of cattle 
and horses held for draft, breeding, dairy, or sporting purposes (such 
as horse racing) was lengthened to 24 months (sec. 1231(b) (3) ). The 
minimum holding period for other livestock held for such purposes 
was lengthened to 12 months.^^ 

One effect of this rule is that many sales of "culls" from a breeding 
herd (animals originally held for breeding purposes but eliminated 
from the herd) are taxable at ordinary income rates, since many culls 
are sold within 24 months. 

Depreciation recapture for livestock 
Livestock depreciation after 1969 was made subject to recapture 
when the animal is sold (sec. 1245). This rule has little adverse effect 
on the fulltime rancher, who typically raises most of his own livestock 
and therefore has no depreciable cost basis in most of his animals. 
This rule adversely affects those farm investors, however, who pur- 
chase breeding animals out of a short-term preoccupation with accel- 
erated depreciation deductions.^^ 

Tax-free exchange of livestock 
The statute was also amended in 1969 to prevent tax-free exchanges 
of livestock of different sexes (sec. 1031 (e) ) . Such exchanges had pre- 
viously been used to enable a rancher (or ranch investor) to build up 
his herd free of current tax by exchanging bull calves, most of which 
are not used for breeding purposes, for heifer calves which could 
be used to increase the size of the herd. 

Activities not engaged in for profit 
This provision limits the current deduction of expenses in an activity 
which a taxpayer engages in other than "for profit" (sec. 183). Al- 
though section 183 is not limited to farm investors, it niay adversely 
affect high-bracket taxpayers who enter farming chiefly as a tax 
shelter. The rule attempts to separate activities which a taxpayer car- 
ries on principally as a hobby or for personal purposes and those 
which he intends to conduct as a profitmaking business. A taxpayer is 
presumed to be engaged in an activity for profit if the activity shows 
a profit in at least two of five consecutive years." If an activity is 
found not to be engaged in for profit, expenses can be deducted only 
to the extent that income derived from the activity exceeds deductible 
interest, taxes and casualty losses. 

^ Before the 1969 Act, the minimum holding period had been 12 months in the 
case of livestock held for draft, breeding, or dairy purposes and 6 months for other 
livestock (including race horses) used in a trade or business. 

" Investors who purchase breeding animals as a long-term investment may 
escape much of the burden of depreciation recapture, because as their herd grows 
larger an increasing proportion will consist of raised offsping which have no 
depreciable basis. Eventually, most of the herd can be sold at capital gain rates 
with little depreciation recapture. 

" This presumption is liberalized to two of seven consecutive years in the case 
of the breeding, training, showing or racing of horses. 



40 

Administrative Rulings 

After a period of litigation over its authority to implement its ruling 
position on the deduction of prepaid feed costs, the IRS has published 
Rev. Rul. 75-152. I.R.B. 1975-17, 15, setting forth administrative 
criteria under which taxpayers on the cash method of accounting can 
deduct payments for feed not consumed during the taxable year of 
payment. In order to be deductible, the payment must not be a deposit ; 
there must be a business purpose for the timing of the feed purchase ; 
and the deduction must not create a material distortion of income. 
If any one of these tests is not satisfied, the Service will permit the 
deduction only as the feed is consumed by the livestock. 

Impact of the 1969 Changes 

Farm tax benefits have been effectively packaged and sold to high- 
bracket taxpayers through limited partnerships and management con- 
tracts for investments in cattle feeding, cattle breeding, tree crops, 
vegetable and other field crops, vineyards, dairy cows, fish, chickens 
and egg production. Some have, therefore, suggested that the 1969 Act 
changes were generally ineffective. 

Table 1 shows the average farm loss reported for tax purposes since 
1969 by individual taxpayers in different income brackets. This table 
shows that farm losses have increased as taxpayers' income levels have 
increased, and that this trend has remained consistent during the three 
years covered by the table. The fact that the largest farm losses are 
concentrated in income levels over $100,000 suggests that high-bracket 
taxpayers make use of the special farm tax rules to shelter nonfarm 
income. 

Since deductions from tax shelters (from farming or other invest- 
ments) reduce a taxpayer's adjusted gross income, Table 1 does not 
show the full extent to which farm losses are being used by wealthy 
taxpayers to shelter nonfarm incomft. 

Table 2 shows the impact of the farm loss recapture rules of section 
1251 of present law. In terms of numbers of returns, the returns which 
show nonfarm income of $50,000 and higher and a net farm loss of 
$25,000 or more have generally been less than one percent of all returns 
which report both nonfarm income and farm losses. In terms of the 
dollar amount of farm losses which are required to be placed in an 
EDA account. Table 2 also shows that section 1251 affects no more than 
8 percent of all farm losses reported on returns which show both non- 
farm income and farm losses. 



41 



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44 

Deferral Shelters Generally 

Present law, as applied to farming investments, focuses largely on 
recfipturing some deductions which otherwise would be used to convert 
ordinary income. 

From a tax shelter point of view, farm investments offer deferral of 
taxes on nonfarm income where deductible expenses are incurred in 
years prior to the years when the revenue associated with them is 
earned." This type of deferral occurs regardless of whether the pro- 
ceeds upon the later sale of the underlying farm products are taxed 
at ordinary income rates or at capital gain rates. 

The period of deferral can be relatively short, involving expenses 
incurred at the end of one calendar year and sales of the farm product 
during the next year, or relatively long (where trees or vines take 7-10 
years to reach a fruit-bearing stage). ^Vhere the deferral period is 
short, the transaction is often referred to as a "rollover" because the 
taxpayer merely delays (or rolls over) the tax on his nonfarm income 
from one year to the next. 

Cattle feeding 

Cattle feeding otters one of the best known and, until recent down- 
turns in the farm economy, most widely used deferral shelters. 

Typically, the investment is organized as a limited partnership or 
as an agency relationship (under a management contract) in which a 
commercial feedlot or a promoter agrees to act as an agent for the 
investor in buying, feeding and managing cattle. Cattle usually weigh- 
ing 400-750 pounds are purchased and then fed special grains and 
other rations in order to increase their weight gain. After being fed a 
specialized diet for four to six months so that their weight increases 
to about 900-1200 pounds, the cattle are sold at public auction to meat 
packers or food companies. 

A cattle feeding venture is typically formed in November or De- 
cember, and utilizes leveraging and the cash method of accounting 
to permit taxpayers with income from other sources to defer taxes 
otherwise due on such income by deducting expenses for prepaid 
feed, interest, and management fees in that year. Usually the amount 
borrowed by the syndicate is sufficient to create tax losses which allow 
the taxpayer to deduct 100 to 150 percent of his own cash investment. 

Income is realized in the following year when the fattened cattle are 
sold. At that time, the bank loans are repaid and any unpaid fees due 
the feedlot (or promoter) are deducted. The balance is distributed to 
the investors. Since feeder cattle are held for sale to customers, sales 
of the animals produce ordinary income. If the investors were to rein- 
vest their profit from one feeding: cycle into another one, they could 
theoretically defer taxes indefinitely on the nonfarm income which 
they sheltered oi-iginally. (To shelter nonfarm income from subse- 
quent years, an additional investment would be required.) 



^^ As indieate<l earlier, where accelerated clepreciation is available on breeding 
herds and orchards nsed in producing annual crops, depreciation c*an also shelter 
the investor's farm income from sales of the annual crop. 



45 

The following example shows how cattle feeding can benefit a tax- 
payer in the 70-percent marginal tax bracket even if the program 
operates at a break-even point economically.^^ Assume that taxpayer 
T invests in a cattle feeding venture on December 15, 1975, and that 
the fattened cattle are sold six months later on June 15, 1976. T's share 
of the deductible expenses incurred in 1975 is as follows : 

Initial investment — 1975 

Cash investment by taxpayer $100, 000 

Borrowings (nonrecourse loans) 250,000 

Total funds available to buy and feed cattle 350, 000 

Purchase price of cattle (750 head at $280 each, not 
deductible) 210,000 

Deductions : ^ 

Prepaid feed for 6 months $105,000 

Prepaid interest at 12 percent for 6 months 15, 000 
Management fee paid to feedlot operator. 20, 000 

Tax loss— 1975 (140,000) 

Tax deferred— 1975 (70 percent) 98,000 

Investor's unrecovered equity- 2,000 

Sale of the cattle — 1976 
Tax results : 

Selling price of cattle ^ $350,000 

Less: basis 210,000 

Ordinary gain 140,000 

Tax liability (70 percent) 98,000 

Cash flow : 

Cattle sales proceeds 350,000 

Less: 

Loan repayment 250,000 

Tax on sale (due Apr. 15, 1977) 98, 000 

After-tax to investor 2,000 



^ Solely for purposes of illustration, it is assumed that the lamounts shown as 
deductions are deductible under present law in 1975. (To be deductible, each of 
the items must meet certain administrative tests. Thus, for example, to the extent 
it represents a prepayment for services to be rendered in 1976, the management 
fee might not be deductible in 1975. ) 

' $100,000 cash investment less $98,000 tax deferral in 1975. 

' The selling price per head is assumed to be $466.67. 

These figures show that the amount of tax which T owes at the end 
of the deferral period equals the amount of his previously deferred tax 



" Solely for purposes of illustration, it is assumed that the program operates 
at a breakeven point. It should be noted, however, that until recent economic 
coinditions, many syndications were structured on the assumption that three of 
every four breeding cycles would be profitable. 



69-542 O - 76 - 4 



46 

($98,000) , plus a current tax on any profit which he makes on the sale 
or minus a tax reduction due to any loss which he suffers.^ ^ 

In order to show the time value to T of having deferred $98,000 in 
taxes on his income for one year, assume that he invests his 1975 tax 
saving in an industrial development bond paying 7 percent interest 
tax free. The tax-free interest earned over the one-year period from 
April 15, 1976 (when T's return for 1975 is due) to April 15, 1977 
(when his return for 1976 is due) would be $6,860. Another w^ay to ex- 
press this benefit is that even though the investment broke even eco- 
nomically, T's average annual rate of return on the cash which he 
invested has been 20.38 percent.^** 

Since the EDA account rule of section 1251 of present law only 
recaptures capital gain on the sale of farm assets, it has no effect on 
the deferral benefit obtained by the taxpayer in this example. The 
portion of the tax loss incurred in 1975 which exceeds $25,000 would 
result in an addition to the EDA of $115,000 but the $140,000 of farm 
ordinary income reported in 1976 would reduce the EDA to zero with 
no adverse effect on the taxpayer. 

Prepaid feed deductions. — Since may, if not most, investors in cat- 
tle feeding shelters become involved in such ventures at the end of 
the calendar year, deductions for prepaid feed for the cattle have been 
central to the creation of tax losses in that year. In recent years, the 
IRS has questioned deductions for prepaid feed claimed by taxpay- 
ers using the cash method of accounting. As noted above, the IRS (in 
Rev. Rul. 75-152) has prescribed several technical criteria and relied 
on its general authority to recompute a taxpayer's income if the tax- 
payer's method materially distorts his income. However, investors in 
cattle feeding shelters may still circumvent the administrative criteria 
in order to justify deductions for prepaid feed. It is to be noted, how- 
ever, that there may be legitimate business reasons for buying feed 
late in the calendar year. Indeed, many who engage in farming as 
this principal occupation generally purchase feed in the fall of the 
year preceding the year during which the feed will be consumed. 

It has been argued that the livestock industry needs outside capital 
and that the tax rules should not be changed to make the attraction of 
new capital more difficult during this depressed period. However, it 
also has been argued that, in view of present concern over funds for 
capital formation, this is an appropriate time to require all invest- 
ment alternatives to compete for investors' funds on the basis of the 
earnings from the economic activity rather than earnings after special 
advantages from tax shelters. 

Shell eggs 
Another deferral shelter which gives even greater writeoffs per in- 
vestment dollar than cattle feeding is the production and sale of eggs. 

" Some feecUot operators who promote cattle feeding programs offer to guar- 
antee that they will purchase an investor's equity for a specified percentage of his 
original investment, or will reimburse him for a percentage (often as high as 80 
percent) of any econcmiic loss which the investor may suffer if cattle prices 
Hhoukl fall. By such a "stop-loss" guarantee, the investors risk of a declining 
cattle market is reduced. 

" The annual rate of return is computed by dividing $6,860 by the sum of the 
amounts invested times the periods over which the amounts were invested. T is 
out-of-pocket $100,000 from December 15, 1975, until April 15, 1976, when his 1975 
return is due. From April 15, 1976, until June 15, 1976, T has only $2,000 invested 
($100,000 less $98,000 in tax reduction) , 



47 

In egg shelters, the entire amount invested and borrowed can be spent 
on deductible items in the first year. Those items include poultry flocks, 
prepaid feed, and a management fee to the person who operates the 
program for the investors (to the extent that it is otherwise deduc- 
tible). Under present law amounts paid for egg-laying hens which are 
commonly kept for only one year from the time they start producing 
are allowable deductions in the year the poultry is purchased." 

In one recent syndicated offering of $6 million in limited partner- 
ship interests in a shell egg operation, the partnership proposed to 
borrow an additional $6 million (in the form of a nonrecourse loan) 
and to spend the proceeds in December of the first year as follows : 

Purchase of flocks $5,400,000 

Purchase of feed, medication and supplies 6, 120, 000 

Initial management fee to general partner (not to be claimed as a 
deduction) 480, 000 

Total 12, 000, 000 

Thus, $11,520,000 of the $12,000,000 would be paid for currently 
deductible items. 

The availability of writeoffs of this magnitude in egg production 
has attracted numerous outside investors in recent years. Many full- 
time farmers have objected to this introduction of outside investors 
into egg production, arguing that shelter-minded investors have dis- 
torted the economics of the egg industry and produced instability in 
egg prices.^° 

Winter vegetables and other plant shelters 

Shelters involving the growing of winter vegetables operate in essen- 
tially the same method as cattle feeding and egg production shelters. 
Invested capital is leveraged to the greatest extent possible and de- 
ductible expenses, consisting of the costs of seeds and young plants, 
planting and cultivation expenses, interest, rent, and management 
fees, are incurred in one year, while the related income is realized in 
margin the following year. 

Similar deferral shelters can be found in the raising of horticultural 
plants where significant expenses are incurred in one year and the re- 
lated income is realized in the following year. For instance, programs 
for raising azaleas and rosebushes have also been used as rollovers 
to defer taxes on nonf arm income from one year to another. 

Deferral and Conversion Shelters 

A deferral and conversion shelter offers an investor an opportunity 
not only to defer taxes in the manner just described but also to convert 
ordinary income into capital gain. The manner in which these bene- 
fits are obtained is by deducting development costs of section 1231 
property (breeding cattle, orchards, vineyards, etc.) and capital gain 
property (farmland) from ordinary income and selling the assets 

'" Rev. Rul. 60-191, 1960-1 C.'B. 78. The purchase cost of this poultry may be 
deducted currently if the farmer consistently does so and if the deductions clearly 
reflect his income. 

'" See Tax Reform Hearings, 94th Cons:., 1st Sess.. 213 (July 15, 1975) (State- 
ment of John Wallace, President, United Egg Producers) . 



48 

developed after holding them long enough to qualify for capital gain 
tax rates. Since the recapture rules which apply to these deducted de- 
velopment expenses are much more limited in scope than depreciation 
recapture rules generally, many farm operations can be structured so 
that there will be little or no recapture of previously deducted devel- 
opment costs. 

Cattle hreeding 

Livestock breeding offers taxpayers the opportunity to defer taxes 
over a period of two or more years and also to convert ordinary income 
to capital gain. 

In general, breeding operations organized to provide tax shelters rely 
on current deductions for prepaid expense items ; current deductions 
for expenses of raising young animals to be used for breeding, dairy, 
draft or racing purposes ; the investment credit ; accelerated deprecia- 
tion and additional first year depreciation on purchased animals and 
equipment ; and capital gain when the mature animals are eventually 
sold. 

Although cattle is the most widely used breeding shelter, there have 
been investments offered for the purchase, breeding and sale of horses, 
(discussed below), fur-bearing animals (such as mink, chinchilla and 
beaver), other types of farm animals (such as dairy cattle and hogs) , 
and some kinds of fish or shellfish. 

In the cattle breeding operation, a herd of heifers and cows is main- 
tained by the investors. The cows in the herd are bred each year and a 
calf crop of 75 to 95 percent is typical. In general, most of the bull 
calves produced each year are sold (often to a feedlot). The rancher 
retains most of the heifer calves which, after about two years, are used 
for breeding. In addition to the bull calves sold, the venture will peri- 
odically sell heifer calves not wanted or needed for breeding opera- 
tions as well as "culls" ( animals which for age or other reasons are not 
needed or suited to the herd). The operation derives its periodic reve- 
nue from the sale of some of these cattle each year. 

The cycle of a breeding herd is about 5-7 years. At the end of that 
period of time, the herd will normally have grown, its quality strains 
will have been established and most of the costs to raise the animals 
will have been deducted as the investors paid them. The investor can 
then sell his raised breeding animals and obtain capital gain with no 
recapture of either depreciation (since the raised animals had a zero 
basis) or of previous development costs (if the investor kept his annual 
farm losses under $25,000). Only the investor's profit on his sale of 
purchased breeding animals will be subject to recapture of previous 
depreciation deductions. 

Table 3 illustrates the substantial tax benefits which a high-bracket 
taxpayer can obtain on a break-even cattle breeding operation con- 
ducted over a five-year period. Assume that T, a taxpayer in the 60- 
percent marginal rate bracket, enters into a management contract on 
November 1, 1975, with a professional rancher for the purchase and 
maintenance of a herd of cattle to be raised for breeding purposes. 



49 

The basic costs in 1975 are as follows: 

Cash investment by T in 1975 $27, 200 

Borrowed funds 46, 800 

Total funds available 74,000 

Purchase cost of breeding animals (200 head at $260 each) 52, 000 

Deductible expenses (1975) : Interest, feed and other maintenance 

expenses, management fees 22, 000 

T will also have to invest additional amounts in the program as 
follows: 1976, $9,800; 1977, $11,000; 1978, $11,400; and 1979, $9,700. 

The loan bears 9 percent interest with principal payments of $5,200 
due in each of 9 years. The breeding herd is assigned a 6-year useful 
life for purposes of depreciation and the investment credit. First-year 
additional depreciation of $4,000 is taken in 1975. The herd is depre- 
ciated under a 150-percent declining balance method. ■* 

The operating results of the herd on an annual basis over five years 
might typically be as shown in Table 3. 



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52 

Assuming that this investment qualifies as an activity carried on for 
profit, T would reduce Ins total tax liabilitv by $16,4^3 (the sum of 
the $54,925 in tax reductions in 1975 through 1970 less the $38,430 in 
taxes due in 1980), on an investment which has neither made nor lost 
money apart frolii taxes. In addition, T lias deferred taxes on his non- 
farm income in the amount of $54,925 (of Avliich $38,430 is only 
deferred and is repaid in 1980) . If the amounts deferred were invested 
in 7 percent tax-exempt industrial development bonds until the taxes 
for 1980 became payable, T would have obtained a benefit of $15,589 
by the time value of dela5dng payment of taxes on his nonfarm income. 
The total benefit from conversion and deferral so computed is $32,084 
($16,495 plus $15,589) on a breakeven project.-^ 

This example also shows the limited scope of the farm loss recapture 
rules of section 1251 of present law. In the first year of this investment 
only $3,000 (the excess of the farm loss over $25,000) need to added to 
an EDA account. Although farm tax losses are incurred in four addi- 
tional loss years, nothing more has to be added to the account because 
the annual losses are less than $25,000. On the facts of this example, 
the EDA rules recapture only $3,000 of tJie farm deductions; an addi- 
tional $47,496 of development costs has been converted from ordinary 
income into a capital gain. 

Horse operations 

Although there appear to be fewer syndicated tax shelters in horse 
breeding and racing than in cattle feeding or breeding, two for- 
mats can be used by taxpayers seeking tax shelter in horse opera- 
tions. In one format, an investor or group of investors buys mares 
(female horses) and conducts a breeding operation. Such ah opera- 
tion can take advantage of accelerated deductions, principally the cur- 
rent deduction of breeding fees (which are paid to another party to 
breed the mares to a stallion) ; expenses during the preproductive 
period of raising the foals; and accelerated depreciation (including 
first year depreciation) on purchased mares. The foals are in some 
cases retained for racing purposes or sold to dealers, usually as 
yearlings. ' 

Income from such sales is ordinary income, since yearlings are by 
definition held for less than 24 months. However, the income is not 
matched with the expenses of raising the foals (since the breeding 

"^ In computing the tax benefits it is assumed tliat all deductions from farming ' 
in 1975 through 1979 offset nonfarm income which would otherwise be taxed in f 
the 60-percent bracket. In computing the taxes in 1980, it is assumed that the \ 
ordinary income is taxed in the 62-percent through 66-percent brackets. The | 
ordinary income is taxed in brackets higher than the 60-percent bracket because ' 
it is bunched in one year. It is also assumed that T has no other capital gains 
during 1980, so that he can use the alternative tax capital gains (a flat 25- 
percent rate). Further, it is assumed that investment credit is recaptured because 
the purchased animals were not held for 60 months. 



53 

fees and maintenance expenses were deducted in a prior year) . Capital 
gains can be generated in a breeding operation when brood mares 
which have been held for more than 24 months are sold. If the mare 
had been purchased, any gain would be recaptured to the extent of the 
depreciation taken on it. If the mare sold had been born to another 
mare in the investor's herd, it would have no basis since all the costs 
incurred in breeding the mare and raising her would have been de- 
ducted previously. Consequently, under present law there would be 
no depreciation recapture and all the proceeds of sale would be capital 
gain except to the extent that the EDA rules of section 1251 apply. 

In the other format, an individual (or group of individuals) buys 
a mare and breeds it to a stallion. The breeding fee is deducted when 
paid (usually upon successful breeding or upon birth of a live foal), 
and the costs of raising the foal are deducted when they are paid. Alter- 
natively the investors may buy a stallion or undivided interests in a 
stallion and then claim depreciation deductions. 

The horse is not generally ready to race until he becomes at least 
two years old. The income derived from racing is ordinary income, but, 
again, it it not matched with the costs of developing the income- 
producing assets. If the owner sells his race horse after or during its 
racing career, capital gain may be realized. An exceptionally success- 
ful horse may generate substantial breeding fees (which are ordinary 
income to the owner) . Alternatively, the owner may syndicate interests 
in the horse to a group of investors who desire to obtain breeding rights 
to the horse (sucli as the syndicate in the case of Secretariat) . Amounts 
received by the owner on such a syndication have been held entitled 
to capital gain treatment. {Harry F. Guggenheim, 46 T.C. 559 (1966) ) . 

Orchards, groves and vineyards 

An investment in an orchard, vineyard or grove involves a "tree 
crop" as distinct from a "field" crop such as vegetables. The list of 
tree crop partnerships covers virtually anything grown in an orchard 
or vineyard in the form of trees or vines which produce annual crops 
of fruits (e.g., apples and avocadoes), nuts (e.g., pecans, pistachios, 
walnuts), or grapes. As indicated earlier, citrus fruits and almonds 
are generally no longer suited to tax shelters because of the cost 
capitalization rule of section 278. 

Tree crops offer investors both tax deferral on their nonfarm in- 
come and potential conversion to capital gain if and when the under- 
lying vineyard is sold (or the investor sells his interest in a syndicate) . 
During the development period of the trees or vines, the owners ob- 
tain deductions from cultivating, spraying, fertilizing and irrigating 
the tree or vine to its crop-producing stage. They also depreciate farm 
machinery, irrigation equipment, sprinkler systems, wells and fences 
which they install on the property. They can also obtain the invest- 



54 

ment credit; and deductions may also be available for interest, fees 
and some prepaid items. ( In some cases, the investors lease the land '' 
on which the vineyard operation is conducted, thereby substituting ii 
deductible ground rents for nondeductible purchase price dollars.) li 

After the trees start producing fruit or nuts, the owners can depre- 1 
ciate the costs of the seedings and their original planting which were 
capitalized when incurred.^^ Such depreciation can partly shelter the ti 
annual crop income. Income from the crop sales is ordinary income. 
Capital gains is also available when the underlying land and the fc 
orchard are sold (except to the extent that various recapture rules [ 
come into play). I 

Table 4 illustrates the shelter available through a limited partner- :| 
ship formed to acquire farm land for planting and developing a grape f< 
vineyard. The crop will include wine and variety grapes which will be I 
marketed as table grapes, crushed into wine or dried into raisins. The } 
transaction shown is based on an actual limited partnership offering u 
which is representative of many vineyard syndications.^^ In this offer- • 
ing, limited partnership shares are sold for $10,000 per unit of interest i 
up to a maximum of 225 Units. The limited partners buy in during ' 
September of the first year and contribute a total of $2,250,000 equity, [f 
The corporate general partner (representing the promoter) contrib-^ 
utes his property rights, including options to acquire the land on which [' 
the vineyard will be developed. ( 

Annual profits and losses will be allocated entirely to the limited f 
partners during the first seven years ; thereafter, the annual allocation !' 
will be 10 percent to the general partner and 90 percent to the limited fl 
partners. ; 

The partnership will purchase 1500 acres of farm land for $3.5 ' 
million, paying $500,000 down and financing the balance by a non- ' 
recourse 9 percent purchase money mortgage. Principal payments will ^ 
not begin until the fourth year of operations ; in that year, principal ' 
payments will begin in annual installations of $150,000 for ten years, 
after which the annual installments increase under a schedule until the 1; 
unpaid balance is paid in full. ^ 
-1 

""liees and vines must be deptreciated over their useful lives in the business. ' 
The useful life is often determined by average industry experience. In some re- J 
gions, for example, apple trees are depreciated over 18 years, fig trees over 25 [ 
years, walnut trees over 33 years, and grape vines over 20-30 years. 

^^ Grape harvests are currently at record high levels, particularly in the case of 
wine grapes. The result is expected to be a period of price reductions for various ' 
domestic wines until demand catches up with the current oversupply. Since grape- 
vines take about 4 years to become productive, some part of the current harvests 
can probably be traced to plantings by tax shelter syndicates during the early 
1970's. 



55 

..The partnership plans to elect the cash method of accounting and 
to use maximum allowable depreciation of buildings, sprinkler sys- 
tems, wells, pumps, stakes and the grape vines. (Vines become eligible 
for depreciation and for the investment credit in the year that grapes 
are first produced in commercial quantities.) 

Each limited partner's tax basis for his partnership interest includes 
his share of the nonrecourse mortgage. Table 4 shows the projected tax 
losses and positive taxable income during the first seven years of opera- 
tions. (Grapevines generally bear commercial quantities of fruit in 
their third year and mature by the seventh year. In this example, since 
the syndicate will begin at the end of the first year, crop revenues bemn 
m the fourth year. ) 

Table 4 shows how maximum advantage is taken of cash method 
deductions for cultivation costs as the vineyard matures from planting 
to full production and, after the productive life begins, of deductions 
tor depreciation and the investment credit (which help shelter part of 
the annual grape revenues). During the first three years, no revenue 
is expected from the young vines. Growing costs, depreciation and in- 
terest deductions ( magnified by leverage) create tax loses which flow 
through to the limited partners and shelter their income from other 
sources. Since the investors buy in late in the first year, they pay in- 
terest for 3 months of that year and also prepay the interest relating to 
year two. The projections also assume (solely for purposes of illustra- 
tions) that the expenses shown are otherwise deductible when paid 
During this period, tax losses totaling $10,405 are available for each 
$10,000 unit. 

• Fo'^/n investor in the 70 percent bracket, this means total tax sav- 
ings of $7,283, which leaves only 27 percent of each original unit unre- 
covered from tax savings. The investment credit further increases the 
effective deferral of taxes on each investor's nonfarm income and 
further reduces his cash left at risk. 

As grape revenues begin coming in, the venture "crosses over" to 
producing positive taxable income and increasing amounts of cash 
flow from annual sales are distributed to the partners. A further in- 
vestment goal not reflected in the table is capital appreciation of the 
underlying land. The value of the property, with maturing vines be- 
ginning to produce major amounts of income, is expected to increase. 
Ihe general partner begins to receive a percentage of net profits and 
the syndicate begins repaying the mortgage, thereby increasing its 
equity in the property. 



56 



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58 

The investors will begin deciding whether to remain in the venture j 
or to sell their interests. If an investor sells his interest in the partner- 
ship, or if the partnership sells the entire farm (including the land if 
and the vines), the investor will be entitled to capital gain treatments 
of any gain he realizes on the land and the vines, except to the extent « 
that recapture is required for previous depreciation (sec. 1245), culti- j 
vation expenses (sec. 1251), or soil and water conservation or land' 
clearing expenses (sec. 1252).^* 

Ranchland leases 

Individual investors and syndicates have often obtained deferral 
and conversion benefits by investing in ranchland which the owners , 
then lease to a local farmer or cattleman. In this type of transaction, i 
the investors become absentee owners of the underlying farm land but 
do not conduct their own farm business. Some public offerings have 
been structured basically as a sale-leaseback under which an existing 
farmer sells his farm to outside investors who then lease the land back : 
to the farmer at a specified rental. Often, the seller /rancher is given an 
option to repurchase the property at the end of the lease at a price 
which will give the investors some profit (and capital gain). 

Under this format, the investors usually use a large proportion of 
borrowed funds to make their initial purchase and to pay many of the 
deductible expenses which they will incur during the term of the 
lease. In this way the investors obtain the advantage of leverage: 
deductions greater than the amount of their own cash investment 
and deductions for interest prepayments (to the extent these are 
available under present law) . During the lease, the investors typically 
upgrade the land and obtain special deductions for soil and water con- 
servation expenses, fertilizer and land clearing costs. They also deduct 
property taxes, maintenance costs and depreciation on barns, silos, 
corrals, fencing and other improvements. Sometimes, the promoters 
of syndicates of this kind act as managers of the farm for the investors 
and charge a management fee, which can also be deducted when paid 
by the investors (provided the payment is for current services) . 

Under present law, the EDA rules of section 1251 may not apply at 
all to this transaction, since the investors might be considered to be 
engaged in real estate rather than in farming. The investment interest 
limitation in section 163(d) does not apply if the lease is not a net 
lease, and many ranchland leases are not net leases. (That is, the own- 
ers rather than the tenant pay most of the operating expenses.) The 
farrn land recapture rules of section 1252 of present law might reduce 
the investors' capital gain if and when they sell the land, but this 
provision would not affect their initial deferral of taxes by means of 
taji; lo^es. 



**The dollar limitations on the EDA rules (sec. 1251) apply separately to each 
partner in a partnership. Therefore, whether any partner must set up an EDA 
account depends on whether he has nonfarm income of more than $50,000 and 
whether he owns enough units so that his share of the partnership's tax losses 
during years 1-3 exceeds $25,000. 



59 

Timber and Christmas trees 

Timber has some of the characteristics of annual crops such as vege- 
tables and fruits, and of minerals extracted from the ground (such as 
gas and oil). It is unlike short-term crops, however, in that timber 
does not replace itself quickly; it is unlike minerals in that it does 
replace itself eventually and, being located above ground, it is rela- 
tively easy to find. Timber growers are permitted to claim capital 
gain treatment on the portion of their income which can be attributed 
to the increase in value of the trees while the trees are growing and 
before they are cut.^^ 

In addition to capital gain, some of the current costs of growing 
timber are deductible currently as paid. These include interest on 
financing an investment in timber, expenses for estimating the inven- 
tory of uncut trees, for salaries and other costs of managing a tree 
farm (such as clearing unwanted trees and brush) , and property taxes. 
To the extent that expenses of growing and carrying timber are 
deducted currently, while the income which the expenses help produce 
is recognized when the timber is later sold, a mismatcliing of income 
and expense occurs. This permits deferral of taxes on a timber owner's 
income from other sources and eventual conversion of the tax rate on 
such income by the capital gain rate for the grown trees. In addition, 
the time value of the deferral is magnified by the long period between 
the taking of the deductions and the receipt of the income. 

The growing and selling of Christmas trees is the most frequent 
form of timber tax deferral shelter. Capital gain is not available if 
Christmas trees are not over six years old when they are cut. Under 
present law, however, costs for shearing, pruning, shaping, weeding 
and thinning trees being grown as Christmas trees have been held to 
be deductible as incurred.^^ 



^° The capital gain preference for timber permits an owner to elect to treat his 
cutting of standing timber as giving rise to capital gkin even though he has 
not actually sold the timber. The gain is measured by the difference between the 
cost of the timber cut and its fair market value on the first day of the taxable 
year in which it is cut (sec. 631(a) ). Any amount realized in excess of the fair 
market value, such as from converting the cut timber to logs, or resulting from 
increase in value after cutting, is taxed as ordinary income. 

^*See, e.g., Daniel D. Kinley, 51 T.C. 1000 (1969), affirmed 70-2 U.S.T.C. Par. 
9462 (2d Cir. 1970) : Rev. Rul. 71-228. 1971-1 C.B. 53. 



5. OIL AND GAS 

General 

In the typical drilling fund, an oil company or promoter (often a 
corporation) forms a limited partnership with itself as the general 
partner. It then solicits additional equity investments in the partner- 
ship from outside parties, who become limited partners. This capital, 
and in some cases borrowed funds, is used to acquire the working or 
operating interest in prospective oil and gas properties and to engage 
in exploratory drilling on these properties. Any borrowed funds are 
usually obtained on a nonrecourse basis, that is, none of the partners 
are personally liable for this debt and the lender must seek repayments 
from specified partnership assets, such as any oil and gas reserves dis- 
covered as a result of the exploration. 

The principal features of oil and gas tax shelters include : 

(1) the immediate deduction of intangible drilling and devel- 
opment costs ; 

(2) the use of leverage through noncourse loans so that the 
limited partners are able to deduct expenses in excess of their 
actual equity investment in the partnership without being per- 
sonally liable on the loans ; and 

( 3 ) conversion of ordinary income into capital gains. 

Types of Shelter Deductions 

Rapid writeoff of expenses; intangible drilling costs 
Under present law, a partner (including a limited partner) is re- 
quired to take into income his distributive share of the partnership's 
income or losses (sec. 702). Generally, the partner's distributive share 
is determined under the partnership agreement (sec. 704). Thus, the 
partner may deduct from his income all of the losses of the partnership 
which are allocated to him under the partnership agreement. 

In the case of the oil and gas drilling partnership, the most im- 
portant (by far) of the expense items which generates large immediate 
losses is the deduction for intangible drilling and development costs. 
The intangible drilling deduction is specifically allowed as an option 
for oil and gas wells under section 263 (c) . Intangible drilling expenses 
include amounts paid for labor, fuel, repairs, hauling and supplies 
which are used in drilling wells, clearing of ground in preparation for 
drilling, and the intangible costs of constructing certain equipment 
such as derricks, tanks, and pipeline which are necessary for drilling. 
But for the statutory election to deduct these costs, they would, in the 
case of a successful well, be capitalized over the life of the well and, 
in the case of a dry hole, be deducted at a time the dry hole is 
completed. 

(61) 



69-542 O - 76 - 5 



62 

The Service has ruled, in Rev. Rul. 68-139, 1968-1 C.B. 311, that 
a limited partnership may earmark a limited partner's contribution 
to expenditures for intangible drilling costs, thereby allowing the 
allocation of the entire deduction to the limited partners (if the prin- 
cipal purpose of such allocation is not the avoidance of Federal taxes) . 
Generally, in the case of a drilling partnership, all deductible items 
are allocated to the limited partners so that they can receive the maxi- 
mum immediate write-off. 

In another ruling in this area, Rev. Rul. 71-252, 1971-1 C.B. 146, 
the Service has ruled that a deduction may be claimed for intangible 
drilling costs in the year paid, even though the drilling was performed 
during the following year, so long as such payments are required to 
be made under the drilling contract in question.^ 

Leverage 

The amount of loss a partner may deduct is limited to the amount 
of his adjusted basis in his interest in the partnership (sec. 704(d) ), 
which is reduced by the amount of any deductible losses (sec. 705). 
Generally, the partner's basis in his partnership interest is the amount 
of his cash and other contributions to the partnership (sec. 722). If 
a partner assumes liability for part of the partnership debt, this also 
increases his basis. However, where the partnership incurs a debt, and 
none of the partners have personal liability (a "nonrecourse" loan), 
then all of the partners are treated as though they shared the liability 
in proportion to their profits interest in the partnership (Regs. 
§ 1.752-1 (e)). The use of leveraging through nonrecourse loans has 
been reduced because of Internal Revenue Service rulings that nonre- 
course loans are to be treated as equity investments where the lender 
is the general partner of the partnership or is a third party who has a 
profits interest in the property (Rev. Ruls. 72-135 and 72-350, as dis- 
cussed above in the "Overview," in part A). Nonetheless, leveraging 
has been continued at least in drilling funds that are not syndicated. 
Moreover, there is no certainty that the position of the Service will 
ultimately be sustained by the courts. 

It should be noted, however, that third-party nonrecourse financing 
is seldom used in exploratory (as opposed to developmental) drilling. 

Conversion of ordinary income into capital gain 
The interest of the lessee in an oil or gas property has been held to 
be "real property used in the trade or business" within the meaning of 
section 1231 (Rev. Rul. 68-226, 1968-1 C.B. 362). The gain from the 
sale or exchange of such property will generally be treated as long- 
term capital gain (except to the extent of anv denreciation recapture 
and issuming a 6-month holding period) unless the property is con- 
sideied to be "held by the taxpayer primarily for sale to customers in 
the ordinary course of his trade or business." ^ An interest in a part- 
ner=!hip is also generally treated as a capital asset (sec. 741) .* 

- See also Rev. Rul. 71-579. 1971-2 C.B. 225. 

' Under section 1231. a taxpayer who sells property used in his trade or busi- 
ness obtains special tax treatment. All gains and losses from section 1231 prop- 
erty are aggregated for each taxable year and the gain, if any, is treated as 
caniHl gain. The loss, if any. is treated as an ordinary loss. 

* This would be the result except to the extent of any unrealized receivables, 
substantially appreciated inventory, and depreciation recapture. 



63 

Thus, if the drilling is successful and the partnership disposes of its 
interest in the mineral property, or the limited partner disposes of 
his interest in the partnership, the income realized by the limited 
partner on his drilling investment would generally be treated as 
capital gain income.^ (Many limited partnership agreements provide 
that the limited partner may have the right to sell his interest to the 
general partner under certain circumstances and subject to certain 
conditions.) In this way, the partner would be able to convert the 
ordinary income deductions based on his contributions to the partner- 
ship, as well as any leveraged amounts, into capital gain.^ 

If, however, the drilling is unsuccessful, no interest would be sold 
at a gain and no conversion of ordinary income to capital gain would 
take place to the extent of the partner's investment. But if the partner- 
ship is financed in part through nonrecourse loans, the nonrecourse 
debt would become worthless (because no oil or gas is found), which 
generally constitutes income to the partnership when the debt is 
foreclosed. This income is treated as capital gain from the "sales" of 
the mineral property (see Commissioner v. Rogers^ 37 B.T.A. 897 
(1938), aff'd. 22 AFTR 1129 (9th Cir., 1939)), and retains this 
character when it is passed through to the partner (sec. 702(b) ) . Thus, 
even in the case of unsuccessful wells, ordinary income deductions are 
converted into capital gains to the extent of any leveraged amounts. 

Operation of Shelter Provision 

The material below discusses some of the issues commonly raised 
with respect to tax shelter investments in oil and gas. 

In general 

Many of the elements which apply to tax shelters generally also 
apply to the oil and gas shelter. 

Deferral of tax exists here, primarily because of intangible drilling 
costs, which are immediately deducted (under sec. 263 (c) ) even though 
the income attributable to those expenses is not realized until later 
years. 

The use of leverage (i.e., nonrecourse loans) in the drilling fund 
situation expands the benefits of deferral by allowing the limited 
partners to claim Federal tax deductions for amounts in excess of their 
economic investment. This result also alters the economic substance 
of the transaction by permitting the taxpayer to deduct money which 
he has neither lost nor placed at risk. 



° If the loan were repaid out of the partnership income, each partner would 
take into income his distributive share of the amounts used for repayment ; the 
partner's basis would not be affected. (The partner's basis would increase to the 
extent that his distributive share of the partnership income was used for part- 
nership purposes, such as repayment of the loan, but his basis would decrease in 
an equal amount because his share of the nonrecourse partnership liability was 
being reduced by the repayment.) 

* There is an argument that the intangible drilling costs deducted by a taxpayer 
might be subject to recapture under present law under the tax benefit theory. For 
example, in Rev. Rul. 61-214, 1961-2 C.B. 60, the Service rule that certain c*osts 
of tangible property, such as tools and supplies, were to be recaptured as ordianry 
income, even though this property was sold as a part of section 337 tax-free 
liquidation transaction. However, it does not appear that there has been any use 
of this approach in the area of intangible drilling costs. 



64 

The conversion of ordinary income into capital gain also occurs in 
connection with the oil and gas shelter. The deferral of tax discussed 
above resulting from the deductions (including leveraged deductions) 
against ordinary income can become a permanent tax savings since 
most (or all) of the income which a taxpayer receives from the trans- 
action will be treated as long-term capital gains. The taxpayer may, in 
effect, cut his taxable income in half, even where he has suffered no 
economic loss. 

It is not clear, even under present law, that taxpayers are entitled to 
all the deductions which are sometimes claimed in connection with the 
oil and gas drilling funds.^ As a result, many participants in these 
shelters may be taking deductions which will later be disallowed by the 
IRS. As a result of this fact, some have argued that unsophisticated 
investors may be lured into investments because of the hope of tax 
benefits which may never be realized. 

Whether or not the tax benefits are realized, some believe that invest- 
ments marketed almost exclusively for their tax advantages, rather 
than on the basis of the underlying soundness of the investment itself, 
can distort the workings of the free market system and may tempt 
taxpayers to invest their money in unwise adventures. This is said to 
occur because, while it is possible for certain taxpayers to make money 
(due to the tax advantages) even when the drilling venture loses 
every cent (see example below), there are other taxpayers who find 
themselves economically worse off as a result of these investments.^ 

Assume that A, whose marginal tax rate is 70 percent, is one of 8 
individuals who invest $100,000 each for a 10 percent profits interest 
in the XYZ drilling syndicate, a limited partnership under State law. 
The general partner, G, who will manage the drilling venture, is en- 
titled to 20 percent of the XYZ profits. The XYZ partnership agree- 
ment allocates all noncapital costs and expenses solely to the limited 
partners. XYZ obtains a nonrecouree loan for $800,000, in return for 
a security interest in its working rights to mineral properties. In the 
same year it was set up, XYZ uses the available cash ($1,600,000) to 
drill oil and gas wells.^ 



' For example, there may be questions as to whether nonrecourse loans made to 
the partnership should be treated as debt (which may be used to increase the 
basis of the limited partners) or an equity investment by the lender (which may 
not be so used). Also, it is the IRS position that syndication costs may not be 
deducted, but these expenses are sometimes claimed as a deduction in connection 
with this shelter. 

* This fate does not necessarily befall the syndicators, who generally charge a 
management fee and charge the costs of syndication to the limited partners. 
Some syndicators contribute capital to the venture, while others do not con- 
tribute any significant amount. If the venture is successful, the syndicator gen- 
erally has a substantial profits interest. Even those syndicators who do contribute 
capital are typically involved in a number of ventures, which gives the syndicator 
a decree of risk spreading that the limited partners do not necessarily have. 

' The deduction may also be taken, in the case of a cash basis taxpayer, if the 
partnership enters into a binding written agreement to have the drilling done in 
the following year (so long as the payments are required to be made under the 
contract), under the doctrine of the Pauley case, 63-1 USTC 9280 (S.D. Cal.) ; 
Rev. Rul. 71-252, 1971-1 C.B. 146. 



65 

A, as a result of these transactions, has the following tax conse- 
quences : A's basis for his partnership interest consists of his equity, 
$100,000, plus his share of the non-recourse loan to the partnership, 
which is 10 percent of $800,000 ($80,000). XYZ, having expended all 
$1,600,000 of its capital on drilling costs, has a deduction of $1,600,- 
000," which is allocated pro rata among A and his fellow limited 
partners. 

A may deduct his share of the drilling expenses, $200,000 (one- 
eighth of $1,600,000), to the extent of his basis of $180,000. (The re- 
maining $20,000 is available for future deductions if A's basis in the 
partnership should be increased.) This deduction will save him $126,- 
000 in taxes. Since he invested only $100,000, the upshot of these 
transactions is a net saving of $26,000. A, of course, retains his inter- 
est in the drilling syndicate. 

Assume that in a later year it is determined that all the wells are 
worthless, the property is foreclosed, and this results in a taxable 
disposition. A would realize a capital gain equal to his share of the 
partnership liability ($80,000) in excess of his basis (zero). Since this 
gain is taxed as capital gain, his tax would be $28,000.^^^ Thus even 
if this taxpayer invested in a completely worthless venture, his partic- 
ipation would cost him only $2,000. (The rest of the cost would be 
borne by the Government.) 

But this does not take account of the value of the deferral which 
the taxpayer has received. Even one year's deferral of $126,000 in 
taxes, at a 7 percent interest rate, would be worth $8,820. In other 
words, the taxpayer would be dollars ahead even if the drilling part- 
nership were completely unsuccessful.^^ 

" Some fraction of this amount might be expended for tangible drilling costs, 
such as drilling tools, pipe, casing, etc., which would have to be capitalized. In 
many partnerships, the general partner will put up some capital, and the part- 
nership agreement provides that the capital items will all be charged to the gen- 
eral partner, in order to give each limited partner a full immediate write-off 
that is at least equal to his basis. 

" Tbis ignores the i)OSsible impact of the minimum tax (sec. 56) and the alter- 
native tax on capital gains (sec. 1201 (d) ) . 

" To some this may appear to be an extreme example, since the drilling fund 
was leveraged, and the taxpayer was in the highest bracket. However, the exam- 
ple assumed that the taxpayer obtained only one year of deferral (whereas longer 
periods of deferral are not uncommon, and the value of the deferral obviously 
depends on the length of the deferral period). Likewise, the shelter in the exam- 
ple was leveraged at a one to one ratio (one dollar of leverage for each dollar of 
investment) but higher ratios of leverage are sometimes attempted. 



6. MOVIE FILMS 

General 

Motion picture shelters generally have two basic forms. In one for- 
mat, a limited partnership is formed to purchase the rights to an al- 
ready completed film. The purchase price is heavily leveraged and 
the partners claim substantial depreciation deductions. The principal 
features of the shelter are deferral and leverage ; also the partners also 
claim the investment credit with respect to the film. This type of deal 
is sometimes referred to as a "negative pick-up" or "amortization 
purchase" transaction. Many of these transactions involve foreign- 
produced films. 

In the second type of format, the limited partnership is formed as 
a production partnership. The production partnership enters into an 
agreement with a studio, with a distributor or with an independent 
producer to produce a particular film. The production partnership 
uses the cash method of accounting and writes oflf the costs of produc- 
tion, as they are paid. The partnership is heavily leveraged and signifi- 
cant costs are paid with borrowed funds. The principal elements of 
this form of motion picture shelter are deferral and leverage. This 
type of shelter is sometimes referred to as a "service company." 

Film Purchase Tax Shelter 

Description of the Shelter 

In this type of transaction, a syndicate of investors, usually formed 
as a limited partnership, purchases a completed film for a cash 
payment plus a nonrecourse note given to the seller (often falling due 
within a range of 7 to 10 years). It is not uncommon for the leverage 
factor in this type of transaction to be 3 or 4 to 1 (i.e. 3 or 4 dollars of 
borrowing for each dollar of equity investment) and sometimes even 
higher. The partnership usually turns over the function of distribut- 
ing the picture to a major studio-distributor (which is sometimes the 
same person who sold the film to the partnership ) , which makes prints, 
arranges showings and handles advertising and promotion in return 
for a percentage of the gross receipts. 

The income from showing the film is divided many ways. A 
substantial share goes to the theater owners who show the film 
locally. The distributor receives a distribution fee and, in addition, it 
is common for the producer and/or the stars of the film to have rights 
to a share of the income. The limited partnership, as the owner of the 
film, has the "negative interest" which is also a right to a certain 
share of the gross receipts. 

As indicated above, however, this negative interest is often heavily 
mortgaged. The nonrecourse note is to be liquidated from the film's re- 

(67) 



68 

ceipts. Some agreements provide that the nonrecourse note must be 
liquidated first, before the limited partners recover any of their own 
equity capital or realize a profit. Other arrangements provide for some 
form of pro rata pay ojff, under which each dollar allocated to the neg- 
ative interest is divided between the noteholder and the limited part- 
ners on some predetermined basis. 

The shelter aspect occurs because of very rapid depreciation of the 
cost of the film (which, of course, includes the basis which is attrib- 
utable to leverage) .^ 

Type of Deduction for Filtn Purchase Tax Shelters 

A . Rapid write-off expenses. 

Under present law, a partner (including a limited partner) is re- 
quired to take into income his distributive share of the partnership's 
income or losses (sec. 702). Generally, the partner's distributive share 
is determined under the partnership agreement (sec. 704). Thus, the 
partner may deduct from his income, generally, all of the losses of the 
partnership which are allocated to him under the partnership agree- 
ment. In the case of the film-purchase shelter, the most important of 
these expense items, is the deduction for depreciation which is com- 
puted under the income forecast method described below. 

B. Leverage 

The amount of loss a partner may deduct is limited to the amount of 
his adjusted basis in his interest in the partnership (sec. 704(d)), 
which is reduced by the amount of any deductible losses (sec. 705). 
Generally, the partner's basis in his partnership interest is the 
amount of his cash and other contributions to the partnership (sec. 
722). If a partner assumes liability for part of the partnership debt, 
this also increases his basis. However, where the partnership incurs a 
debt, and none of the partners have personal liability (the "nonre- 
course" loan), then all of the partners are treated as though they 
shared the liability in proportion to their profits interest in the part- 
nership (Regs. § l.'752-l(e) ). 

Generally, in this type of transaction, most or all of the profits 
interest in the partnership (and therefore most of the leverage) is 
allocated to the limited partners. 

C. The income forecast method 

Motion pictures are usually depreciated on the "income forecast" 
method. (Rev. Rul. 60-358, 1960-2 C.B. 68; Rev. Rul. 64-273, 1964-2 
C.B. 62.) This method is used because, unlike most other depreciable 
assets, the useful life of a motion picture is difficult to ascertain. Under 
the income forecast method, the taxpayer computes depreciation by 
usins: a fraction, the numerator of which is the income received from 
the film during the year and the denominator of which is the total esti- 
mated income which the film is expected to qrenerate over its remain- 
ing lifetime. This fraction is then multiplied by the basis of the film. 
For example, if the taxpayer lias a basis of $500,000 in his interest in 
the film, the income from the film through the end of the first year is 

^ Although relatively insignificant, the deduction of syndication fees is also 
a factor in some of these shelters. 



69 

$750,000, and the total estimated income from the fibii over its lifetime 
is $1,000,000, the taxpayer would be allowed to depreciate 75 percent 
of his basis, or $375,000. (If the income forecast increases or decreases 
as a result of changed circumstances, this is taken into account for 
later periods. Thus, in the second j^ear, depreciation imder the income 
forecast method might be based on an income forecast denominator 
which was more or less than the amount used for the first year.) 

D. Depreciation recapture 

There is some question as to whether a movie film in the hands of a 
limited partnership, such as those described here, w^ould constitute 
a capital asset (within the meaning of sec. 1221), or "property used 
in the trade or business" of the taxpayer which is neither "inventory," 
nor "property held by the taxpayer primarily for sale to customers 
in the ordinary course of his trade or business" (Avithin tlie meaning 
of sec. 1231).^ There is certainly an argument that wliere the limited 
partnership owns a single film, which it did not produce, and which 
it holds for a period of years, such property should be viewed as a 
section 212 investment,^ or as 1231 property which is not inventory 
and is not held "primarily for sale." On the other hand, the Service, 
in applying these provisions to movie films, has applied the primarily 
for sale principle on a broad basis wliicli might well reach many of 
the fact situations involved in these shelters. (Sec Rev. Rul. 62-141, 
1962-2 C.B. 182). 

If the film is not a capital asset (or section 1231 property), any 
income received with respect to the film would be ordinary income. 
Assuming that the film is foimd to be a capital asset, income realized 
on ihQ sale or exchange of the film would be subject to the depreciation 
recapture rules of section 1245. Thus, the proceeds of the sale in excess 
of the taxpayer's adjusted basis would constitute ordinary income to 
the extent of any depreciation previously allowable with respect to the 
film.* 

Even if the film is not sold, there should eventually be recapture of 
the depreciation attributable to the nonrecourse note. If the film is 
successful and the loan is repaid out of the partnership income, each 
partner would take into income his distributive share of the amounts 
used for repayment; the partner's basis would not be affected. (The 
partner's basis would increase to the extent that his distributive share 
of the partnership income was used for partnership purposes, such 
as repayment of the loan, but his basis would decrease in an equal 
amount because his share of the nonrecourse partnership liability was 

^ Under section 1231, a taxrpayer who sells certain property used in his trade 
or business obtains si)ecial tax treatment. All gains and losses from section 1231 
property are aggregated for each taxable year and the net gain, if any, is treated 
as capital gain. The net loss, if any, is treated as an ordinary loss. 

* Section 212 permits the deduction of expenses paid or incurred for the 
production of income, or for the management, conservation or maintenance of 
property held for the production of income. 

* If the partner sold his interest in the partnership, the depreciation would 
be recaptured as an "unrealized receivable" under section 751. 



70 

being reduced by the repayment.) If the film is not successful and the 
nonrecourse debt becomes worthless, this generally constitutes income 
to the partnership when the debt is foreclosed, because the foreclosure 
is treated as a "sale" of the movie film, (See Commissioner v. Rogers^ 
37 B.T.A. 897 (1938), aff'd 22 AFTR 1129 (9th Cir., 1939)), which 
is subject to the recapture rules of section 1245.^ 

How the Shelter Works 

As a practical matter, there is relatively little sheltering effect where 
the total estimated revenues to be received from the film exceed the 
purchase price paid for the film.^ Where the projected income stream 
of the film is less than the purchase price, and depreciation is based on 
the income forecast method, the depreciation deduction claimed by the 
limited partners will exceed the amount of income from the film which 
the partners are required to recognize. 

Tax shelter benefits are the greatest where the limited partnership 
"pays" more for the film than its economic value. Much of this pay- 
ment, of course, is in the form of a nonrecourse note, the payment of 
which is dependent on the receipts from showing of the film. 

Assume, for example, that prior to commercial release of a com- 
pleted film, the limited partnership pays the production studio 
$1,000,000 for the film, consisting of $200,000 cash and a 10-year non- 
recourse note of $800,000. After the film is released, it becomes appar- 
ent that it will not be successful and will not generate box office 
receipts equal to the purchase price paid by the investors. The film is 
reappraised and it is now determined that its estimated income over 
its lifetime will not exceed the $200,000 cash down payment. If this 
reappraisal proves accurate the depreciation and income which would 
be passed through to the limited partners over the following 10 years 
would be as follows : 



^ Likewise, if the partnership discontinues its operations, this should consti- 
tute a constructive distribution of the partnership assets (including, for this 
purpose, the unpaid portion of the nonrecourse note) to the partners, which in 
turn triggers the recapture rules of section 1245. However, it is by no means 
clear that all taxpayers follow sound tax accounting principles at this point in 
the shelter transaction, and much of this income may be "forgotten". When 
this occurs, it is diflScult for the Internal Revenue Service to detect unless there 
is a field audit. 

° This is easiest to illustrate in a case where the income stream is greater than 
the purchase price. For example, if the film is purchased for $2 million (and 
has this as its basis) , but has an estimated income stream of $4 million, $3 million 
of which is earned during the first year, the result would be as follows. The 
partners would be allowed to take 75 i)ercent of their $2 million basis as deprecia- 
tion in the first year under the income forecast method (or a $1,500,000 deduc- 
tion). However, the film would be also generating $3 million of income which the 
partners would have to recognize. Thus, the net tax effect would be positive tax- 
able income to the partners of $1,500,000. Where the purchase price of the film 
and its estimated income stream are exactly equal, the depreciation deduction and 
the amount of income from the film should exactly offset each other. 



71 





Percent of 
revenue 


Revenue 


Deprecia- 
tion 


Tax loss 


Year: 

1 

2 

3 

4 

5- 

6-10 


80.0 

10.0 

5.0 

2.5 

1.0 

1.5 


$160, 000 

20, 000 

10, 000 

5,000 

2,000 

3,000 


$800, 000 
100, 000 
50, 000 
25, 000 
10, 000 
15, 000 


($640, 000) 
(80, 000) 
(40,000) 
(20, 000) 
(8, 000) 
(12,000) 


Total 


100.0 


200, 000 


1, 000, 000 


(800, 000) 



At this point, the investors might default on the note, and the part- 
ners would have to recognize $800,000 of income.^ This $800,000 is the 
same as the cumulative deductions which they had taken over the ten 
year period. Since the major portion of these accelerated deductions 
would have occurred in the early years, the value of the deferral on 
these amounts would be substantial. (For example, a $640,000 loss was 
generated in the first year) . 

Assuming that the taxpayer was in the 70-percent bracket, a $640,000 
loss would save him $448,000 in taxes. At a 7-percent rate of interest, 
compounded annually for 9 years, the value of the deferral on the first 
year's loss alone is about $375,000. 

The total income from a film might be less than the purchase price 
paid by the investor. This can occur for one of several reasons. Estimat- 
ing the probable income stream from a motion picture is difficult. 
Generally films are purchased before they are distributed to the public. 
There are ways of estimating the income stream, even at this point 
(for example, by examining the results of private screenings, the dis- 
tribution contracts, and the promotional efforts of the distributor), 
but there is also a highly subjective element involved, and it is possible 
to make good faith mistakes in valuation which can be substantial.^ 

Some believe that the necessarily subjective process of valuation 
presents an abuse potential which is sometimes exploited. This belief 
is based on the premise that, while the limited partners have an arms- 
length interest in seeing to it that their down payment is not excessive 
in view of the actual value of the film. They have little to lose, however. 



"" In most cases, all, or a substantial part of the $200,000 income from the film 
would have been used to reduce the amount of the nonrecourse note. Thus, the 
amount which the partners' would have to take into income would generally be 
less than $800,000. Economically, however, the deferral on the $800,000 of ac- 
celerated deductions would end at this point, because the combination of the 
amount which the partners would be required to take into income, plus their 
real economic loss on the $200,000 of equity investment, would total $800,000. 

* Another factor which may help to explain a disparity between the purchase 
price paid for a film, and a lower "income forecast" is that taxpayers are not 
required to include projected income from television rights as part of the in- 
come forecast, if the film is American made, and no television contract has been 
entered into. Rev. Proc. 71-29, 1971-2 C.B. 568. But, in many cases, the potential 
revenues from television rights are taken into account in determining the pur- 
chase price of the film. 



72 

in paying an inflated sales price which is represented only by a nonre- 
course note. Although an inflated sales price will reduce the partner's 
ultimate profits, should the film prove to be successful, many of the 
investors of this type of limited partnership are alleged to be far more 
concerned with immediate tax benefits than with the speculative pos- 
sibility of profits which may or may not materialize in the future. 

From the standpoint of the seller, it can afford to be generous in 
terms of the size of the note it is willing to take. If the film is successful, 
the note will be paid and the seller's profits will be relatively large; 
if the film is a failure, the seller still has the cash down payment in the 
bank, plus whatever amounts on the note have been paid off. 

Thus, according to this line of argument, both parties to the trans- 
action may have little incentive to place a low value on the film at the 
time it is sold to the limited partnership, to the extent that the pur- 
chase price is represented by the nonrecourse note. On the other hand, 
as indicated above, the tax advantages which can result from a high 
overvaluation of the film can be substantial. 

Questions Under Present Law 

As explained above, film purchase transactions produce substantial 
tax shelter benefits only where the purchase price of the film (includ- 
ing nonrecourse indebtedness) exceeds its economic value. 

There is a substantial question under present law whether taxpayers 
in a film-purchase shelter are legally entitled to claim depreciation 
which is based on nonrecourse indebtedness where the "purchase price" 
of the film is in excess of the income pre cost on the film. 

While the authorities in this area have not been uniform, there are 
several cases which have disallowed the depreciation deduction based 
on nonrecourse liability where there was no substantial prospect that 
this liability would be discharged. In Leonard Marcus, 30 T.C.M. 1263 
(1971) , the court held that where the taxpayer purchased two bowling 
alleys for a 5 percent down payment, with a 20-year nonrecourse note 
for the balance, the taxpayer could depreciate only the basis repre- 
sented by his down payment, and that the note could be taken into ac- 
count for purposes of increasing the taxpayer's basis only to the extent 
that payments were actually made. The court held that the liability 
represented by the note was too "contingent" to be included in basis 
until payments were made.^ 

In Marvin M. May, 31 T.C.M. 279 (1972), the Tax Court held that 
a transaction in which the taxpayer purchased 13 television episodes 
for $35,000, and obligated himself to pay an additional $330,000 on a 
nonrecourse basis was a sham, because this amount was far in excess 
of the fair market value of the films and there was no realistic prospect 
(or intention) that the debt Avould ever be paid. Therefore the Court 
disallowed the depreciation deduction claimed with respect to the film. 
The facts of May were rather extreme, however, because the taxpayer 
apparently made no effort to ascertain the value of the films before 
his "purchase," and there were a number of other factors suggesting 

"In Marcus, the 20-year term of the note was substantially in excess of the 
useful life of the bowling alleys. 



73 

that the transaction was not bona fides. See also, Rev. Rul. 69-77, 
1969-1 C.B. 59.1° 

It would seem that some of these same principles could often be ap- 
plied in the case of a film purchase shelter, where the purchase price 
of the film consists largely of nonrecourse indebtedness and substan- 
tially exceeds the film's income forecast. However, to date at least, the 
uncertainties of present law have not deterred the use of this type of 
shelter, perhaps because each court case turns on its own facts, the re- 
sults of litigation in this area have not been uniform, and taxpayers 
and their counsel who take an interest in tax shelters tend to be 
optimistic. 

The Production Company Transaction 

Description of the Shelter 

In this type of arrangement, the limited partnership enters into an 
agreement with a distributor to produce a motion picture. Generally 
the distributor's requirements in connection with the film are spelled 
out in some detail, and the distributor will generally retain some 
rights of quality control including, for example, the right to request 
added scenes and retakes. The limited partners typically have no 
knowledge of the motion picture business and the production services 
are managed by the general partner or an individual producer who 
is (directly or indirectly) pre-selected by the distributor. (In some 
cases, the partnership subcontracts the actual production work to a 
production company owned by an independent producer.) 

The financing for the production costs of the film comes from capi- 
tal contributions by the limited partners and a substantial nonre- 
course loan, which may be made by a bank, but is guaranteed by the 
distributor. It is common for partnerships of this type to be leveraged 
in a ratio of 3 or 4 to 1, and higher ratios of leverage are not unheard 
of. 

The limited partnership does not have any ownership interest in the 
film. The total fee which the partnership receives generally equals 
the cost of making the film plus a potential profit. Frequently, there is 
a guaranteed or "fixed fee" which equals the bank loan and must be 
paid over to the bank as soon as the partnership receives it. There is 
also a contingent portion of the fee which is based on a percentage 
of the income from the film. Often there is a ceiling on this contin- 
gent fee (in other words, a maximum fee which will not be exceeded 
even if the film is very successful). Sometimes the total fee is pay- 
able over a i^eriod of 6 or 7 years after which the investors' rights 
terminate. 



°As indicated above, under the partnership provisions, the partner may add 
to his basis in the partnership his share of the nonrecourse liabilities. However, 
section 752(c) provides that "a liability to which property is subject" shall be 
considered as a liability of the owner of the property "to the extent of the fair 
market value of such property . . ." Since the "fair market value" of a movie 
film can hardly be in excess of its projected lifetime earnings, this suggests that 
a partner's basis cannot include his share of nonrecourse indebtedness to the 
extent that this in'^eb^^'^dness (plus the partners' down payment) exceeds the 
income forecast for the film. 



74 

The partnership elects the cash method of accounting, and deducts 
the production costs of the film as they are paid. Naturally no income 
is generated during the production period because the fihn has not 
been completed. 

When the film is distributed, the partners are required to recognize 
their respective shares of the partnership income, including the income 
which is used to discharge the nonrecourse loan. However, there has 
been a period of deferral which varies from deal to deal, depending on 
the fee schedule provided under the agreement with the distributor 
and, to some extent, on the success of the film.^^ It is common for the 

?ayments under the contracts to be spread over a period of about 6 or 
years, with the larger payments coming at the end, to maximize the 
tax benefits of deferral for the limited partners. 

Since the partnership will have deducted its expenses in the first 
year (instead of capitalizing them), it will have no basis in the fee 
payments when they are received, and the entire amount will be tax- 
a,ble income which will be passed through to the partners. (If the 
partnership has already begun producing another picture, the deduc- 
tions from the new picture may shelter all or part of the income from 
the first picture.) ^^ Eventually, all of the deductions claimed by a 
partner in excess of his actual investment will have to be included 
in his income, but the benefit of deferring his tax liability for a lengthy 
period of time can be considerable. 

The "service company" format thus differs from the "negative pick- 
up" transaction because the investors do not own the completed pic- 
ture. The distributor or the independent producer owns the picture 
and claims depreciation and the investment credit.^^ 

Example. — In 1975 an independent producer, P, owns a screen play 
which he wants to develop into a film. P interests D, a major studio- 
distributor, in guaranteeing part of the financing of the project in 
return for exclusive distribution rights to the film. The budget for 
the picture is $2 million. P obtains the services of a promoter who 
solicits investors for a limited partnership (in which the general part- 

" The possibility that the limited partners will realize an economic profit on 
their investment may deipend to a great extent in the success of the film. How- 
ever, the success or failure of the film does not determine the success of the 
shelter to nearly the same extent as in the film purchase shelter type deal. This 
is precisely because the length of the period of deferral for the production com- 
pany partners depends on the fee payment schedule, which can be controlled 
under the contract. Generally part of the fee payments are contingent on profits, 
but are not to exceed a stated amount for a given year, regardless of film's 
(profitability: (As discussed above, in the film purchase deal, if the film is suc- 
cessful, there should be no shelter effect from the transaction because income 
should equal or exceed the accelerated deductions. ) 

" Some recent syndicates have combined investments in completed pictures 
with production of new pictures. In this way, excess depreciation from the com- 
pleted picture can effectively shelter income received under the production 
contract. 

"Another variation of this shelter (although not as widespread) is the film 
distributor partnership. In this shelter, the partnership also does not own an 
interest in the film. The partnership obligates itself to distribute the film and 
writes-off the costs of distribution. Deferral occurs because the partnership's 
income from its distribution services is not realized until later years. 



75 

ner is a corporation formed by the promoter) . Ten individuals, each 
in the 60 percent tax bracket, agree as limited partners to contribute a 
total of $500,000 to the capital of the partnership. The partnership 
then obtains a nonrecourse loan for the balance of the budget cost 
(secured by the partnership's right to payment and by a guarantee 
from D) . The project is thus financed as follows : 

Investors' equity (25 percent) $500,000 

Bank loan (i5 percent) 1,500,000 

Total cost 2,000,000 

The limited partnership contracts to make the picture from the 
screen play and to deliver the negative to P. Simultaneously, P con- 
tracts with D to deliver the completed film to D. The partnership 
agrees to deliver the completed film to D on or before January 1, 1976, 
and the partnership will receive $3 million in installments as follows : 
A fixed amount of $1,500,000, payable without regard to box 
office receipts, as follows: $1,200,000 on January 1, 1977, and 
$300,000 on January 1, 1978 ; 

30 percent of $2,750,000 of D's grosses after D first grosses 
$2,500,000 from the film ; 

25 percent of the next $2,700,000 of D's grosses. 
The fixed fee is earmarked to be paid over to the bank when it is 
received by the partnership. (The partnership is entitled to interest 
on the fixed fee at the same rate it must pay on the bank loan.) The 
partnership's rights to payments terminate in all events after seven 
years. Net profits (after payment to the service company) are divided 
equally between P and D. 

The partnership elects to use the cash method of accounting and 
hires the necessary personnel. The picture is made within its budget, 
all of which is expended during 1975. On January 1, 1976, the com- 
pleted film is delivered to the distributor. Assume that the movie is 
successful and that the investors receive the full profit they expect. 
The partnership's tax and cash flow results are expected to be as fol- 
lows (if the production cost deductions are upheld) : 



76 



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77 

If the deductions are upheld, the partnership will have written off 
all of its production costs (including all the investors' equity) in its 
first year of operations. The investors will have deducted $4 for each 
$1 they invested. In the 60 percent tax bracket, this means that each of 
the ten investors has deferred $120,000 in current taxes on his other 
income. Having put up $50,000 in cash, each investor has effectively 
recovered all of his cash investment and also obtained use of an extra 
$70,000 of tax dollars which he would otherwise have paid to the 
Treasury. 

Tyye of Deduction for '"'• Production Company'''' Shelter 

The basic principles of partnership tax law which were discussed 
above in connection with the film purchase shelter also apply to pro- 
duction company shelters. These include the use of the partnership 
form to allow the limited partner to take into income his distributive 
share of the partnership's income or losses (which are generally deter- 
mined under the partnership agreement). The amount of loss which 
the partner may deduct is limited to the amount of his adjusted basis 
in his interest in the partnership, which includes not only his own 
contribiitions to the partnership, but also his share (which is based on 
his profits interest in the partnership) of any nonrecourse debt which 
the partnership has incurred. However there are several questions of 
law which arise only in connection with the "production company" 
type shelter. 

A. Cash method of accounting 

Obtaining tax deferral through a production company transaction 
depends on whether the partnership can properly deduct its costs of 
producing the film as it pays them. This in turn depends on whether 
proper tax accounting practices permit the partnership to treat these 
costs as an item of expense or require the partnership to capitalize these 
expenditures and amortize them over the life of the asset. (In this 
case, the asset is the partnership's rights under the contract with the 
distributor-owner of the film.) 

Under present law, a taxpayer is generally permitted to select his 
own method of accounting (sec. 446(a)) unless the method selected 
"does not clearly reflect income" (sec. 446(b) ). If it does not, the law 
permits the IRS to compute the taxpayer's income in a way that 
will clearly reflect his income. 

Thus, the question here is whether failure to capitalize the expenses 
of producing the film (and thus, of the partnership's rights under the 
contract) results in a material distortion of income. There is a strong 
argument under present law that a material distortion of income does 
occur under these circumstances. See Commission v. Idaho Poioer 
Co.^ 418 U.S. 1 (1974), holding that "accepted accounting practice" 
and "established tax principles" require the capitalization of the cost 
of acquiring a capital asset, including costs, such as depreciation on 
equipment, which would generally be deductible if they were not 
allocable to the construction of the asset. (The production company's 
contract rights are not a capital asset, but these rights are an asset 
with a long useful life, so there is a strong argument that the capital- 
ization principle should apply.) 



78 

On the other hand, there is one case relied on heavily by the indus- 
try which held that a building contractor's income was not distorted 
where the company constructed apartments and shopping centers 
under long-term construction contracts and deducted its costs on the 
cash method, while receiving payments over a five-year period after 
each project was completed. G . A. Hunt Engineering Co.^ 15 T.C.M. 
1269 (1956) . Production company investors have argued that the same 
result should be allowed in their situation.^* 

A related question is whether the limited partnership is engaged in 
selling or delivering a product (the film) and is therefore required to 
maintain an inventory. If this were the case, the labor costs paid 
in producing the inventory could not be deducted until the inventory 
item was sold. The argument against that view is that the partnership 
does not own the film at any time. Thus, it is argued that the produc- 
tion company is selling services (i.e. production services) rather than 
a product. The Service has ruled that building contractors (operating 
under circumstances arguably analogous to movie production com- 
panies) are selling "services" rather than "property." (See Rev. E.ul. 
73^38, 1973-2 C.B. 156.) 

B. Other issues 
In some cases, the personnel hired by the partnership to make the 
film are not in reality the investors' own employees but are supplied 
by the distributor. This factor, along with others, raises questions 
under present law whether a particular service company is really 
engaged in a joint venture with the distributor (in which case it would 
have to capitalize its production costs). Issues such as these must be 
resolved on the facts of the particular situation, such as the nature 
of the investors' rights to compensation, the distributor's day-to-day 
involvement in production, etc. 

Operation of Shelters 

Both of the two types of basic formats which are commonly em- 
ployed in connection with movie films, the film purchase shelter and 
the production company shelter, have the same basic elements, i.e., the 
use of deferral and the use of leverage. In the case of the film purchase 
shelter, the deferral occurs because of the very rapid depreciation which 
is allowed in connection with movie films, and which is passed through 
to the limited partners, particularly in cases where the film is not 
economically successful. In the case of the production company, the 
mismatching of expenses and income occurs because the partnership 
deducts the full cost of producing the film before the film is released 
and because the contract which the limited partnership enters with the 
"owner" of the film often provides that payments to the production 
company for its "services" will be spread over a relatively long time 
period. 

^*In 1973, the Internal Revenue Service issued a few private rulings that a 
movie production partnership may use the cash method of accounting in deduct- 
ing movie production costs as they are paid. Since 1973, however, the Service 
has refused to rule favorably in this area and has set up a study group to look 
further into the merits of the issue. 



79 



non- 



Both types of arrangementc involve the use of leverage (i e nuu- 
recourse loans) which allow the limited partners to receive Federal tax 
deductions for amounts in excess of their economic investment Some 
argue that nonrecourse financing distorts the economic substance of 
the transaction by permitting the taxpayer to deduct money which he 
has neither lost nor placed at risk. In the case of movie shelter, the use 
ot heavy leverage factors of 3 or 4 to 1 is typical. 

The "service company," format, in particular, has become increas- 
ingly popular. A special report on movie tax shelters in Business Week 
magazine entitled "How to Invest in Movies," August 25, 1975, states 
that over half the films produced in the U.S. today are financed through 
leveraged service partnerships. Some of the recent films produced in 
this way are "Funny Lady," "Shampoo," "Day of the Locust," "Bite 
the Bullet, "The Harrad Experiment," and "The Great Gatsby." The 
result of deducting the entire cost of the film, usually in one year, and 
of high leveraging, this article states, "is a 400% -of -investment write- 
ott— a tax shelter that ranks with the best that real estate, oil, or cattle 
ever offered." 



7. EQUIPMENT LEASING 

General 

A business may acquire productive equipment in a variety of ways, 
including an outright purchase or a lease of the equipment. The use 
of leasing as a means of acquiring productive equipment has grown 
substantially in the past fifteen years. Some of the more common types 
of property and equipment which are presently leased include aircraft, 
computers, railroad rolling stock, ships and vessels, cable television 
systems, and oil drilling rigs. Also, utility companies have begun to 
lease nuclear fuel assemblies. 

There are two basic types of equipment leases. The first is the so- 
called "net" lease. Under the net lease, the equipment is leased for a 
rental term approximating the useful life of the property, with the 
lessee assuming financial responsibilities which are normally those of 
the lessor (such as paying property taxes and insuring the property) . 
Rent payments under a net lease also are ordinarily at a level which 
enables the lessor to service debt incurred to purchase the property, 
pay any other expenses, and provide a minimal positive cash flow. As 
a result, the lessor has very little risk under the net lease. 

The other basic type of lease is the "operating" lease, under which 
the lessor assumes a significantly greater degree of risk than under 
the net lease. The operating lease is generally for a term less than the 
useful life of the property, and the lessor is responsible for paying 
such expenses as insurance and property taxes. Since this type of lease 
is for a relatively short term, and the original rentals by themselves 
will not pay off the debt incurred to purchase the property, the lessor 
in an operating lease takes the risk that rentals from subsequent leases 
of the property will be insufficient to service the financing costs and 
cover other cash flow expenses. There are significant differences be- 
tween the tax treatment accorded net leases and operating leases. For 
example, individuals who lease equipment under an operating lease 
may be allowed the investment credit, while the credit would not be 
available under a net lease. 

The equipment leasing shelter is a "deferral" type of shelter. Tax 
shelter benefits arise largely from postponing income taxes on income 
from other sources through losses generated by accelerated deductions 
during the early yeare of the equipment lease. The principal acceler- 
ated deductions are for depreciation under one of the accelerated 
methods, rapid (60-month) amortization, and prepaid interest. In 
addition, the use of leverage, through nonrecourse loans, is an integral 
part of the equipment leasing shelter. The lessor also may be eligible 
to claim the investment credit, however, the availability of the invest- 
ment credit was substantially curtailed by the Revenue Act of 1971. 

(81) 



82 

Description of the Shelter 

As is the case in many other types of tax shelters, the limited part- 
nership is commonly used in the equipment lease transaction where 
sheltering of investors' income from other sources is a primary goal. 
In the typical equipment leasing shelter, a limited partnership is 
formed with the equity capital provided by a number of individual 
investors who become limited partners. The promoter, often a corpora- 
tion, is the general partner. Virtually all of the equity capital 
is provided by the investors (generally in amounts of not less than 
$5,000 each) , with the general partner contributing little or no equity. 

Prior to soliciting limited partnership interests, the promoter has 
often located a company which is interested in leasing computers, rail- 
road rolling stock or some other type of business machinery or equip- 
ment, and has contacted a bank, insurance company or other lender to 
arrange for financing the equipment purchase. After the limited part- 
nership interests have been sold and the equity capital received, a 
large portion of the equity capital usually is used to make a 20-25 
percent down payment to purchase the equipment. The remaining part 
of the purchase price generally is financed on a nonrecourse basis, so 
that the lender's security for his loan is limited to a security interest 
in the equipment with neither the partnership nor any of the partners 
having personal liability for the debt. (As a practical matter, the 
lender's primary security is the credit rating of the lessee and the 
lessee's ability to make the rental payments over the period. 

The partnership generally leases the equipment to the lessee at a 
rental rate which, over the initial term of the lease, will enable the 
partnership to repay the loan, plus interest, fees and other expenses, 
and generate a modest positive cash flow. 

In most leasing shelters, the limited partnership elects the method 
of depreciation or amortization which will generate the largest capital 
recovery deductions allowable in the early years of the lease. The 
partnership may, in addition, prepay some of its interest charges, and 
often, during the first year of operation, pays the promoter for man- 
agement and syndication fees. The large depreciation, fees, interest, 
and other expenses generally exceed the partnership's receipts from 
rental of the equipment during the first 3-7 years of the lease (depend- 
ing upon the estimated useful life of the leased equipment), and this 
generates sizable losses for the partnership. 

Partnership losses are allocated to the investor-limited partners 
under the partnership agreement and are used by the individual in- 
vestors to offset income from other sources (and thus defer taxes on 
this income for a number of years.) The individual investor may also 
obtain an apportioned share of the investment credit if the equipment 
is eligible for the credit and the lease is of a type which enables an 
individual investor to claim the credit. 



83 

Types of Shelter Deductions 

Depreciation 

A. Accelerated depreciation 

The owner of tangible personal property used for the production of 
income is entitled to a deduction for depreciation. (Where a partner- 
ship owns the property, the depreciation deduction is passed through 
to the individual partners, generally in accordance with the partner- 
ship agreement.) 

All tangible personal property may be depreciated on a straight- 
line basis, which provides that an equal portion of the property's basis 
(less salvage value) is deducted each year of the property's life. Tan- 
gible personal property used for the production of income (such as 
airplanes, computers and cargo containers) is eligible for "accelerated" 
methods of tax depreciation which allow large deductions initially, 
with gradually reduced deductions for each successive year of the 
asset's useful life. The accelerated depreciation methods allowed for 
equipment include the double-declining balance method ^ and the sum- 
of-the-years-digits method.^ 

A comparison of these accelerated depreciation methods with 
straight-line depreciation is illustrated by the following example in- 
volving an asset which cost $1 million and has a 10-year useful life. It 
is also assumed that salvage value is less than ten percent and there- 
fore can be ignored, (sec. 167(f) .) 

Under either of the accelerated methods shown above, the total de- 
preciation deductions in the earlier years of an asset's life substantially 
exceed total depreciation allowable under the straight-line method. 
This is not the case, however, in later years. In the above example, the 
depreciation to be claimed under the double declining balance method 
is less than under the straight-line method after the fourth year. 
Straight line depreciation exceeds sum-of-the-years-digits deprecia- 
tion after the fifth year. 



^ The double declining balance method of depreciation, also known as the 200 
percent declining balance method, allows a depreciation rate equal to twice the 
straight-line rate. The declining balance rate is applied to the unrecovered cost, 
i.e., cost less accumulated depreciation for prior taxable years. Since the depreci- 
ation base is reduced to reflect prior depreciation, the amount claimed as de- 
preciation is greater in earlier years and declines in each succeeding year of an 
asset's useful life. 

^ The sum-of-the-years-digits method of depreciation is computed using a frac- 
tion, the numerator of which is the years' digits in inverse order and the de- 
nominator of which is the sum of the number of years. For example, if an asset 
has an estimated useful life of 10 years, the denominator is the sum of one plus 
2 plus 3, etc., plus 10, or 55. The numerator would be 10 in the first year, 9 in 
the second year, etc. Thus, in the first year, the fraction would be 10/55, in the 
second year 9/55, etc. As in the case of the declining balance method, the annual 
depreciation is greater in earlier years and declines in each succeeding year of 
an asset's useful life. 



84 






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85 

B. Additional first-year depreciation 

An owner of equipment is also eligible to elect, for the first year 
the property is depreciated, a deduction for additional first-year de- 
preciation of 20 percent of the cost of property (Sec. 179) . The amount 
on which this "bonus" depreciation is calculated is limited to $10,000 
($20,000 for an individual who files a joint return). Bonus deprecia- 
tion is also available only for property that has a useful life of 
six years or more. The maximum bonus depreciation is then limited 
to $2,000 ($4,000 for an individual filing a joint return) . 

Where the lessor is a partnership, the election for bonus deprecia- 
tion is made by the partnership. However, the dollar limitations de- 
scribed above are applied to the individual partners rather than the 
partnership entity. For example, each one of 40 individual investors 
who contributed $5,000 to an equipment leasing limited partnership, 
which purchased a $1 million executive aircraft on a leveraged basis, 
would be entitled to $4,000 of bonus depreciation if he filed a joint 
return. In this case, additional first-year depreciation alone would 
provide total deductions of $160,000 to the partners. 

The additional first-year depreciation I'educes the depreciable basis 
of the equipment. However, the partnership is still entitled to claim, 
and the partners to deduct, accelerated depreciation on the reduced 
basis in the property both for the first year and for the later years of 
the property's useful life. 

C. Asset Depreciation Range {ADR) 

The ADR system for depreciation was authorized by the Congress 
in the Revenue Act of 1971 in order to help bolster a lagging economy 
and to eliminate a number of difficult interpretative problems pertain- 
ing to depreciation which had arisen under prior law. The ADR sys- 
tem operates under regulations issued by the Treasurj^ Department, 
and became effective in 1971. (Reg. § 1.167 (a)-ll.) 

Under ADR, depreciation for tangible personal property (includ- 
ing leased property) may be calculated using a shorter than otherwise 
allowed useful life. The depreciation lives allowed under ADR may 
be 20 percent shorter than the lives established by the In- 
ternal Revenue Service as reasonable useful lives for depreciation of 
productive assets. (Rev. Proc. 62-21, 1962-2 C.B. 418.) This means, 
for example, that an asset with a useful life of 10 years may instead be 
depreciated over a period of 8 years under ADR, giving the taxpayer a 
type of "accelerated" depreciation deduction (even with straight-line 
depreciation).^ 

D. Rapid amortization 

Certain categories of assets which are subject to equipment leasing 
transactions are eligible for rapid amortization. Under the rapid 
amortization provisions, the costs for qualifying categories of property 
may be amortized over a period of 60 months in lieu of depreciation 

' In computing depreciation under the ADR system, a taxpayer also is entitled 
to use one of two first-year "conventions." or methods, on all assets first placed 
in service dnrins any one tax year or period. Under the first of these conven- 
tions, the taxpayer may elect to claim a half-year's depreciation on all assets 
put into service at any time during' the year. The other convention allows a full 
year's depreciation for all assets placed in service during the first half of the 
tax year and no depreciation (for the first year) on assets placed in service 
during the last half of the tax year. 

69-542 O - 76 - 6 



86 

deductions otherwise allowable for these assets. Rapid amortization is 
allowed for pollution control facilities, (sec. 169), railroad rolling 
stock (sec. 184), and coal mine safety equipment (sec. 187). These 
provisions terminated at the end of 1975, however there is considera- 
tion for continuing these provisions. 
E. Depreciation recapture 

The equipment leasing shelter does not give rise to the "conversion" 
characteristic of many other types of shelters because of the full 
recapture rules that apply to tangible personal property. (Sec. 1245.) 
When tangible personal property is disposed of at a gain, the gain is 
"recaptured" as ordinary income to the extent of all previous depreci- 
ation deductions claimed on the property (not just accelerated deduc- 
tions). The recapture treatment for tangible personal property differs 
from that accorded depreciable real property, which is generally lim- 
ited to a recapture of the amount by which accelerated depreciation de- 
ductions claimed exceeded those allowable on a straight-line basis. 

In the case of a partnership, the individual partners are generally 
allocated a share of the partnership's depreciation recapture in accord- 
ance with the provisions of the partnership agreement concerning the 
allocation of partnership gains. The recognition of depreciation re- 
capture by a partner may be triggered directly by a sale of the de- 
preciated partnership property or indirectly by a disposition of the 
partner's interest in the partnership itself. Also, if a lender fore- 
closes on the debt used to finance the partnership's purchase of the 
equipment, this is treated as a disposition which will trigger recapture. 
The amount "received" in a foreclosure will include the unpaid non- 
recourse debt. If this amount exceeds undepreciated basis' in the 
equipment, there will be so-called "phantom gain" which is taxed as 
ordinary income to the partners. 
Investment Credit 

As items of tangible personal property used in a productive capac- 
ity, the properties used in equipment leasing transactions are gen- 
erally eligible for the investment credit, which, under the Tax^Re- 
duction Act. of 1975, was increased to 10 percent through 1976. 

An individual lessor (or individual investing in a limited partner- 
ship leasing transaction) may claim the investment credit only in two 
limited alternative situations.^ (Sec. 46(d) (3).). In the first situation, 
a noncorporate lessor is allowed the investment credit if the property 
subject to the lease was produced or manufactured by the lessor. lii 
the second situation, a noncorporate lessor will be allowed the invest- 
ment credit where the term of the lease (including any renewal 
options) is less than 50 percent of the depreciable life of the property, 
and, for ih^ first 12-month period after the property is rented to the 
lessee, the sum of the lessor's ordinary and necessarv business deduc- 
tions (under section 162) exceeds 15 percent of the lessor's rental 
income from the property. This is intended to allow the investment 
credit to an individual (or a limited partner) only where the investor 
are willing to accept the risks of a short-term '"operating" type of 

^ The maximum credit which may be claimed for anv one year by a married 
taxpayer filing a joint return is limited to $25,000 plus 50 percent of the tax lia- 
bility over $25,000. This limitation is applied separately to each partner in a 
partnership. 



87 

equipment lease. Thus, the investment credit is not available in the 
typical net lease situation. 

Leverage 

The amount of loss a partner may deduct is limited to the amount 
of his adjusted basis in his interest in the partnership. (The partner's 
adjusted basis is reduced by the amount of any deductible partnership 
losses.) Generally, the partner's basis in his partnership interest is the 
amount of his cash and other contributions to the partnership. If a 
partner assumes liability for part of the partnership debt, this also 
increases his basis. However, under the regulations, where the part- 
nership incurs a debt and none of the partners have personal liability 
(a "nonrecourse" loan), then all of the partners are treated as though 
they shared the liability in proportion to their profits interest in the 
partnership and their bases are increases accordingly. (Regs. § 1.752- 
1(e).) 

IRS Rulings Policy 

Treatment of the lease as a conditional sale 

In equipment leasing transactions the partnership's claim that the 
transaction is a lease may be challenged by the Internal Revenue 
Service and treated instead as a sale of the equipment by the partner- 
ship. The treatment of such leases as sales will result in a total elimi- 
nation of sheltering characteristics, including disallowances of the 
lessor's depreciation. ^ 

The Service has long been aware of the problem of determining 
whether a transaction is a lease or is in reality a sale with long-term 
financing. For a number of years, the Service has had a series of guide- 
lines to determine the income tax treatment of purported leases of 
equipment. (See Rev. Rul. 55-540. 1955-2 C.B. 39.) Early in 1975, the 
Service set out criteria under which it will rule on whether a trans- 
action is a lease. Under these criteria it will not rule that a leveraged 
lease of equipment constitutes a lease unless : 

(1) The lessor's equipment purchase is leveraged to an extent 
less than 80 percent of cost. 

(2) At the end of the lease term (including all renewal periods 
except option periods at a fair market rental rate), the leased 
property has a residual value of at least 20 percent of its original 
cost, and a remaining useful life of either one year or 20 percent 
of the property's original useful life, whichever is longer. 

(3) Any option to purchase by the lessee is based on the fair 
market value of the property at the end of the lease term. 

(4) Neither the lessee nor any person related to the lessee (under 
section 318(a) ) furnishes part of the lessor's cost of the property 
or anarantees any of the lessor's purchase indebtedness. 

(5) The lessor demonstrates that it expects to receive an eco- 
nomic profit from the lease, apart from that generated by tax 
benefits. 

(6) The level of rental payments also satisfies certain other 
criteria. 

If the lease does not meet these tests, the Service will not give an 
advance ruling on the lease transaction. Of course, the taxpayer is 
free to test the validity of the transaction in court, if challenged on 
audit by the Service. 



88 

Operation of Shelter 

Equipment leasing transactions are in some cases the only feasible 
way that some businesses are able to acquire modern equipment. How- 
ever, it is equally true that equipment leasing attracts investors in high 
tax brackets for whom the tax deductions and credits are more valu- 
able in terms of their income after taxes than would be their earnings 
on a direct equity investment. For the lessor, the accelerated deprecia- 
tion and relatively short useful lives of the assets represent significant 
tax deferral. Moreover, these deferral benefits are magnified apprecia- 
bly by the use of leverage. Because of the recapture rules presently 
applicable in the case of equipment leasing, there is no conversion of 
ordinary income into capital gains. 

The reasons why the business firms which lease the equipment use 
this form of financing, rather than purchases or other traditional 
methods of acquiring equipment, vary considerably among industries. 
One significant factor that frequently influences the decision is the 
inability of the company to take full advantage of the investment 
credit and/or rapid depreciation deductions because of low profits or 
losses. Equipment leasing may also be desirable because the firms 
might otherwise be unable to finance the acquisition of new equipment. 
However, equipment leasing may, in the case of the lessee firms and 
industries, deter structural adjustments necessary to restore the rate of 
return or investment to a competitive level. In addition, the use of 
special tax deductions in these cases tends to divert investments to firms 
where investments may not be economic and in this way distorts the 
allocation of investment funds among all industries. This means that 
investable funds do not go to the most productive investment 
opportunities. 

In addition, business firms which finance the acquisition of equip- 
ment in this fashion increase their contractual payments, which has 
much the same effect on them as an increase in their debt. 

The equipment leasing industry is highly leveraged and vulner- 
able to interruptions in the flow of payments. If the lessee is encounter- 
ing unexpected losses and defaults on his payments, the sequence of de- 
faults through the linkage of financial arrangements limits loanable 
reserves of lending institutions more than would be the case with more 
traditional routes for financing equipment acquisitions. 

Because of the present tax situation, when an investment is solicited 
in an equipment leasing venture, it has become common practice to 
promise a prospective investor substantial tax losses which can be used 
to decrease the tax on his income from other sources. 



8. PROFESSIONAL SPORTS FRANCHISES 

General 

The professional sports industry provides entertainment in the form 
of competitive sporting events, such as baseball, basketball, football, 
hockey, etc. The industry is organized into various joint associations or 
leagues consisting of individual teams or franchise members. The 
league members are subject to various league rules which generally 
have the effect of restraining economic competition. For example, con- 
sent of most of the members teams is normally required to grant a new 
franchise or approve the move of an existing member team from one 
city to another. 

The assets of a professional sports team may generally be divided 
into three categories: (1) sports and office equipment; (2) contract 
rights for services of players and other personnel for a specific period 
("player contracts") ; and (3) franchise rights granted under the 
league or association agreement. In certain acquisitions, goodwill may 
also be involved. The professional sports franchise is a contractual 
right for an indefinite term which entitles a team to various rights, 
such as the exclusive territorial right to provide sporting events in 
a given geographical area, the right to participate in and obtain play- 
ers through the college draft, the right to participate in receipts from 
radio and television contracts, and the benefit of league rules and regu- 
lations restricting business competition among the member clubs. 

Although the operation of many sports teams has not resulted in 
taxable profits in recent years, the cost of acquiring a sports franchise 
has increased significantly. In addition, the upward trend in acquisition 
cost does not appear to have been dampened by those cases where actual 
economic losses have been sustained.^ Some feel that this is due in large 
part, to the various tax provisions that allow owners to use losses from 
sports franchises to shelter income from other sources. These tax pro- 
visions provide tax deferral and other tax benefits that can result in 
profitability from an investment which reflects losses for tax or finan- 
cial accounting purposes. The major tax benefits in the sports industry 
are : 1) the deferral of tax payments for one or more years and 2) the 
conversion of income (ancl the tax rate) from ordinary income to 
capital gain. 

Tax deferral usually results from the current or rapid deduction 
of costs from which benefits are derived in later years, i.e., the rapid 



^According to an article in U.S. News and World Report, at least 10 out of 
24 major baseball teams, 25 out of 28 major basketball teams, and 11 out of 14 
major hockey teams incurred a taxable loss in 1970. However, all of the 26 major 
football teams either broke even or made an economic profit. "Pro Sports : A 
Business Boom in Trouble," U.S. News and World Report, Vol. 71 (July 5, 
1971), p. 56. 

(89) 



90 

writeoff does not accurately represent the actual cost of the exhaus- 
tion of an asset. Tax deferral is enhanced if the portion of an aggre- 
gate purchase price allocable to depreciable assets having a short useful 
life is maximized. The principal cost that can be deducted rapidly, or 
before the related income is recognized in the sports industry, is the 
cost of a player's contract. Conversion occurs where capital and de- 
velopment costs have been deducted as depreciation or as a salary ex- 
pense against ordinary income and then, in a later year, the sports 
franchise is sold at a capital gain. 

The entities most commonly used to maximize tax benefits for 
an individual investor in the sports industry are partnerships and 
subchapter S corporations. These two forms of ownership are used 
since they are conduits which permit an individual to use the losses 
generated by the franchise to offset other income such as salary or 
dividends. However, not all sports franchises are organized as partner- 
ships or subchapter S corporations. 

Types of Shelter Deductions 

Depreciation and Amortization 

Under present law, the cost of tangible property used in a taxpayer's 
trade or business may be depreciated and deducted over the useful 
life of the property. In general, the use of accelerated methods for 
computing depreciation are permitted if the asset has a useful life of 
3 years or more. 

In addition, the cost of certain intangible property used in a taxpay- 
er's trade or business can be amortized and deducted over the useful 
life of the property if certain conditions are met.^ Te be deductible, the 
property must have a useful life which is limited in duration and 
which can be estimated with reasonable accuracy. No deduction is al- 
lowed if the useful life of the property is not ascertainable. Unlike 
tangible property, the use of accelerated methods of depreciation is 
not permitted for intangible property. 

Gains from the sale of both tangible or intangible property are sub- 
ject to recapture of depreciation as discussed below. 

A. Player contracts 

Players' contracts are intangible assets and usually represent one of 

the significant costs of acquiring a sport franchise. "Wliile the players' 

contracts vary with the type of sport involved, the typical contract 

will provide employment for one year and give the employer (tlie 



" A deduction for the exhaustion of usefulness of an intangible asset used in a 
trade or business is treated as a depreciation deduction although for financial 
accounting purposes the deduction may be described as an amortization expense 
and distinguished from depreciation attributable to tangible property. 



91 

team) a unilateral option to renew the contract for an additional year 
at a specified percentage of the player's previous year's salary.^ 

Prior to 1967, the cost of an individual player's contract was de- 
ducted as an ordinary and necessary business expense for the taxable 
year in which paid or incurred depending on the owner's method of 
accounting. This treatment was based on the theory that individual 
player's contracts had a useful life of one year or less.* However, the 
bulk purchase of players' contracts was treated by the IRS as an acqui- 
sition of one indivisible asset which was to be amortized and depreci- 
ated over the useful life of the players. (Rev. Rul. 54-441, 1954-2 C.B. 
101.) 

In 1967, the IRS reversed its position with respect to individual 
baseball contracts and ruled that the cost of a player's contract must 
be capitalized and depreciated over the player's useful life. (Rev. Rul. 
67-379, 1967-2 C.B. 127.) In adopting this position, the IRS noted 
that by reason of the reserve clause, a player contract has a useful life 
extending beyond the taxable year in which the contract was aquired. 
In Rev. Rul. 71-137, 1971-1 C.B. 104, the same result was reached 
with respect to football contracts by virtue of the option clause under 
the contract.^ Although the useful life varies from sport to sport, 
sports teams typically adopt a maximum life of between three and six 
years. The cost to be capitalized includes amounts paid or incurred 
upon purchase of a player contract and bonuses paid to players for 
signing contracts. 

Since franchise rights are not usually depreciable because these 
rights exist for an unlimited period of time, a purchaser of a sports 
team will benefit from larger depreciation deductions if he is able to 
allocate more of the aggregate purchase price to player contracts and 
less to franchise rights. Under present law, there are no specific statu- 
tory rules relating to the manner in which allocation must be made. 
However, the allocation of an aggregate purchase price among the 
various assets must reflect the relative value of each asset to the value of 
the whole.^ 



' Baseball and hockey contracts contain a specific "reserve clause" in which the 
right to renew the contract is itself renewed. Although the team obligates itself 
for only one year, the effect of this reserve clause in the contract, and certain 
league rules, is to bind the player to play only for the team which owns the con- 
tract. Under league rules, if the player refuses to sign a new contract or play 
for an additional year under the terms contained in the original contract, the 
team can prevent the player from playing for another team. Basketball and 
football player contracts purport to be less restrictive in that, although they 
provide an option for an additional year's contract, they do not contain a reserve 
clause per se. Neither the contract nor the league rules prevent the player from 
"playing out his option" and becoming a "free agent." However, in the case of 
football, if a player becoming a free agent signs a contract with a different team 
in the NFL, then unless mutually satisfactory arrangements have been reached 
between the two league teams, the Commissioner of the NFL can assert the right 
to award to the former team one or more players (including future draft choices) 
of the acquiring team. This right is currently being litigated. 

* Commissioner v. Pittsburgh Athletic Co., 72 F. 2d 883 (3d Cir. 1934) ; Com- 
missioner V. Chicago National League Ball Club, 74 F. 2d 1010 (7th Cir. 1935) ; 
and Helvering v. Kansas City American Assn. Baseball Co., 75 F. 2d 600 (8th Cir. 
1935). 

^ Depending upon the outcome of the litigation involving the reserve clause, the 
IRS position may be less tenable. 



92 \ 

The depreciable basis of player contracts also affects the current 
capitalization and depreciation of bonus payments to be made in the * 
future under the terms of the contract. Generally, an accrual basis 5 
taxpayer is entitled to deduct an unpaid expense for the taxable year ? 
in which all the events have occurred which determine the fact of [ 
liability and the amount can be determined with reasonable accuracy 
(Treas. Re^. § 1.461-1 (a) (2)). Under this general rule, accrued sal- ! 
aries would ordinarily be deductible expenses for the taxable year in 
which earned by the employees even if paid in the following taxable ' 
year. However, any expenditure which results in the acquisition of an , 
asset having a useful life which extends substantially beyond the close 
of the taxable year may not be deductible for the taxable year in which i 
the liability for the expenditure was incurred. This limitation would \ 
generally apply to amounts required to be capitalized with respect to' I 
a liability for future payments under a player contract. t 

In addition, another specific limitation would also apply in the case s 
of such a contract if it is treated as a nonqualified deferred compensa- ; 
tion plan. 

An employer is not entitled to deduct contributions made to or under 
a nonqualified deferred compensation plan until the taxable year in 
which an amount attributable to the contribution is includible in the 
gross income of the employee (sec. 404(a)(5)). The employee- 
beneficiary of a nonexempt trust must generally include amounts paid 
on his behalf in his taxable year in which there is no substantial risk 
of forfeiture (sees. 83, 402(b), and 403(c) ). In addition, the Internal 
Revenue Service has ruled that if compensation is paid by an employer 
directly to a former employee, under an unfunded plan, such amounts 
are deductible when actually paid in cash or other property (Rev. 
Rul. 60-31, 1960-1 C.B. 174) . Thus, it would seem that deduction under 
an unfunded plan before payment would be precluded where the useful 
life of the player contract is shorter than the actual payout period.^ 

B. Franchises 

A professional sports franchise is an intangible asset. Under present 
law, however, depreciation or amortization deductions are not al- 
lowed since the useful life of the franchise is not of limited duration 
and cannot be ascertained. The cost or basis of the franchise would 
be taken into account in determining gain or loss upon sale or other 
disposition of the franchise. 

^Harlow v. Davock. 20 T.C. 1075 (1953). Treasury Regulation section 1.167 
(a) -5, relating to apportionment of basis, provides that in the case of a lump sum 
purchase of property the basis for depreciable property cannot exceed an amount 
which bears the same proportion to the lump sum as the value of depreciable 
property at the time of acquisition bears to the value of the entire property at 
that time. 

* However, one author has suggested that "whether player 'signing' bonuses 
are correctly treated as an anomaly among the forms of deferred compensation 
is not clear." (Klinger, "Professional Sports Teams: Tax factors in buving, own- 
ing and selling them" 39 .1. Tax 276 (Nov. 1973).) On the basis of the Service's 
ruling that ".signing" bonuses are treated as costs of acquiring player contracts 
(Rev. Rul. 71-137. 1971-1 C.B. 104) and since the contracts are amortizable in- 
tangible assets, that author suggests that deduction before payment "seems to 
be permissible" where the useful life of the contract is shorter than the payment 
period. Thus, the author suggests that deductions could be generated without 
cash expenditures. 



93 

C. Sports and Office Equipment 

Sports and office equipment are tangible personal property which 
can be depreciated over their respective useful lives. Unlike player 
contracts and franchise rights, these assets may qualify for the invest- 
ment credit and additional first year depreciation. 

In the typical case, the cost for equipment represents an insignifi- 
cant portion of the total cost of a sports franchise. 

Capital Gain Treatment 

A. Sales of franchises 

In general, in the case of the sale or exchange of a franchise, any 
recognized gain or loss is treated as capital gain or loss, if the fran- 
chise has been held by the taxpayer for more than 6 months (Rev. Rul. 
71-123, 1971-1 C.B. 227). Since the franchise is not a depreciable 
asset, it is not treated as a section 1231 asset (as described below). In 
addition, an exchange of one franchise for another would be treated as 
a like-kind exchange under which the recognition of gain is post- 
poned except to the extent "boot" (i.e., money) is received. 

Under a special provision (sec. 1253) , the sale or exchange of a fran- 
chise will not be treated as the sale or exchange of a capital asset if 
the transferor retains any significant power, right, or continuing inter- 
est with respect to the subject matter of the franchise. Plowever, a spe- 
cific exemption is provided for the transfer of a franchise to engage in 
a professional sport. 

B. Player Contracts 

Under present law, depreciable property that is used in a trade or 
business is not treated as a capital asset. However, under section 1231, 
a taxpayer who sells depreciable property used in his trade or business 
obtains special tax treatment. All gains and losses from section 1231 
property are aggregated for each taxable year and the gain, if any, is 
treated as capital gain. If the losses exceeded the gains, the loss is 
treated as an ordinary loss. Thus, gains from the sale of player con- 
tracts and sports equipment will be treated as capital gain and subject 
to the more favorable capital gain rates if the contracts were held for 
more than 6 months. 

Recapture of Depreciation 

Before 1962, net gains from the sale of personal property used in a 
trade or business (with certain exceptions) were taxed as capital 
gain, and losses were generally treated as ordinary losses. In 1962, sec- 
tion 1245 modified this treatment as to most personal property to "re- 
capture" gain on the sale as ordinary income to the extent of all depre- 
ciation taken on that property after December 31, 1962. Accordingly, 
the Internal Revenue Service has ruled that gains from the disposition 
of depreciable professional baseball and football player contracts 
which are owned by teams for more than 6 months are subject to recap- 
ture as ordinary income." Further, in the case of an early disposition 
of sports equipment, there will also be recapture of the investment 
credit. 



' Rev. Rul. 67-380, 1967-2 C.B. 2&1 ; Rev. Rul. 71-137, 1971-1 C.B. 104. 



94 



11 



Leverage 

The amount of loss a partner may deduct is limited to the amount i 
of his adjusted basis in his interest in the partnership (sec. 704(d) ), 
which is reduced by the amount of any deductible losses (sec. 705). 

Generally, the partner's basis in his partnership interest is the 
amount of his cash and other contributions to the partnership (sec. 
722) . If a partner is personally liable for part of the partnership debt, 
this also increases his basis. However, under the regulations, where the 
partnership incurs a debt and none of the partners have personal lia- 
bility (a "nonrecourse" loan), then all of the partners, including lim- 5 
ited partners, are treated as though they shared the liability in propor 
tion to their profits interest in the partnership (Regs. § 1.752-1 (e)) 

With respect to a subchapter S corporation, losses that may be passed i 
on to a shareholder are limited to the amount of his investment in the 
stock and any loans he has made to the corporation. There is thus no 
resulting tax benefit to the shareholder of a subchapter S corporation 
if the corporation uses nonrecourse financing. 

Form of Ownership 

The forms of ownership most commonly used to maximize tax 
benefits in the sports industry are the partnership and the subchapter 
S corporation. In general, a partnership is not considered a separate 
entity for tax purposes; rather, the individual partners are taxed 
currently on their share of the partnership gains and may deduct 
partnership losses to the extent of their partnership basis. Similarly, 
the tax incidents of a subchapter S corporation's operations are gen- 
erally passed through to its individual shareholders. Both the limited 
partner and the shareholder may deduct losses of the partnership of 
cubchapter S corporation to the extent of the adjusted basis in the 
partner's interest or the shareholder's stock. 

While the adjusted basis of the shareholder's stock in a subchapter S 
corporation does not include any portion of the corporation's liabilities 
( other than loans than an individual shareholder makes to the corpo- 
ration) , it is possible to increase the adjusted basis of the shareholder's 
stock by making annual loans to the corporation. These forms of 
ownership allow an individual investor to use the loss generated by 
the sports team to offset or "shelter" other income of the investor, such 
as salary or dividends. 

Example of Sports Shelter 

In 1976, Mr. Sport and his 3 partners acquire a professional sports 
franchise for $10 million ($2 million in cash and $8 million in long- 
term notes bearing interest at 10 percent principal payments begin- 
ning in 1980). The assets of the franchise include the franchise rights, 
players' contracts, sports and office equipment, and a stadium lease, 
the unexpired term of which is 10 years. The partnership allocates 15 
percent of the purchase price to the franchise, 80 percent to the play- 
ers' contracts, 3 percent to equipment and 2 percent to the stadium 
lease. A useful life of 5 years is adopted with respect to the players' 
contracts and a useful life of 10 years is adopted with respect to the 
equipment. The equipment is depreciated using the straight-line 
method. Mr. Sport has other personal income of $500,000 in 1976 and 
has a one-fourth share in the profits and losses of the partnership. 



95 

For the taxable year 1976, the partnership has the following income 
id expenses : 

r>nmo • 



Income : 

Gate receipts $2, 900, 000 

Television and radio income 1, 400, 000 

Parking and concessions 345, 000 

Other income 80, 000 

Total income 4, 725, 000 

Expenses : 

Player salaries 1, 700, 000 

Coaches, scouts, and staff 350,000 

Front office administration and overhead 1, 050, 000 

Training 175, 000 

Interest 800, 000 

Lease rental 100, 000 

Total expenses 4, 175, 000 

Net income before depreciation (cash flow) 550,000 

Depreciation : 

Player contracts 1, 600, 000 

Equipment 30, 000 

Lease acquisition cost 20, 000 

Total depreciation 1, 650, 000 

Net loss for year 1, 100, 000 

Based upon the foregoing assumptions, one-fourth of the net loss 
from the partnership would have the following effect upon Mr. Sport's 
tax liability ^ and cash position. 

Without With Cash 

team team benefits 

Other taxable income $500,000 $500,000 

Net loss for team (275, 000) 



Taxable income 500, 000 225, 000 

Income tax liability 321,000 128,500 



Taxsavings 192, 500 

Cash flow from team 137, 500 



Total tax savings 

and cashflow ^ 339^ 000 

1 For purposes of this example, the maximum tax on earned income was not used 
(i.e., none of the $500,000 was earned income). 

2 If another investment opportunity is foregone because of the $500,000 invest- 
ment in the franchise, the cash benefits attributable to this investment should be 
adjusted downward to reflect the after-tax income foregone. For example, if 
Mr. Sport could have invested the $500,000 in taxable securities at a 10 percent 
yield, the cash benefits attributable to the investment in the franchise would be 
reduced by $15,000 ($50,000 income less income tax of $35,000). 



96 
Operation of Tax Shelter 

The principal elements involved in the use of a professional sports 
franchise as a tax shelter are deferral and capital gains treatment upon 
the sale or disposition of the franchise or the assets. In many cases, 
these tax benefits combine to transform an otherwise unprofitable 
investment into a very profitable one. The tax benefits derived from in- 
vestino- in sports franchises have increased the price of franchises and 
permitted the operation of some marcjinal teams which might not be 
in existence but for the tax savings attributable to deferral and con- 
version allowed by existing law. Because tax losses may be generated 
which can be used to offset other income, professional sports fran- 
chises have become increasingly attractive tax shelter investments for ' 
individuals in high marginal tax brackets. 

One practice that increases the tax benefits resulting from the opera- 
tion of a sports team is the allocation of a large part of the amount paid 
or incurred for the acquisition of a sports team to depreciable player 
contracts. Typicallv, a purchaser of a sports team attempts to allocate 
as much as possible of the aggregate purchase price of the franchise 
to player contracts because the cost of a plaver contract may be depre- 
ciated over the useful life of the player. Amounts that are allocated 
to other assets such as the franchise rights or to goodwill cannot be 
depreciated since these assets have an indeterminate usefid life. The 
effect of allocating a greater amount of the purchase price to player 
contracts is to decrease the amount of taxable income or increase the 
amomit of tax losses attributable to the operation of the sports team 
during the early years.^ + 



* Of the total cash consideration paid for an expansion ma.ior league football 
team, the Atlanta Falcons, the purchaser (a subchapter S corporation) treated 
$7,722,914 as the cost of player contracts and options, $727,086 as deferred interest 
and the remaining $50,000 as the cost of the franchise. This resulted in tax losses 
to the corporation of $506,329 in 1967 and $581,047 in 1968 which was passed 
through to the shareholders on a proportionate basis. Upon audit, the IRS de- 
termined that only $1,050,000 should be allocated to the player contracts and 
options, and $6,722,914 should be allocated to the nondepreciable cost of the Na- 
tional Football League franchise. Tlie taxpayer paid the additional assessment, 
submitted a claim for refund, and after its disallowance, filed a suit for refund. 
The court rejected both the taxpayer's initial allocation of $7,722,914 and the 
Commissioner's allocation of $1,050,000 and concluded that the amount that 
should have been aUocated to the plavers' contracts and options wns $.^.035,000. 
(Laird v. U.S., 391 F. Supp. 656, 75-1 U.S.T.C. 88,565 (D.C. Ga. 1975) ). The court 
further concluded that $4,277,043 represented the value of the television rights 
granted to the Atlanta Falcons under a 4-year contract between the NFL and 
the CBS television network and that this amount was not amortizable because 
the useful life of the television rights was for an indefinite period. This case is 
presently on appeal in the Fifth Circuit. 

Questions have been raised as to the method used by the District Court in allo- 
cating the purchase price to the various assets acquired in the Loird case. First, 
the court did not appear to allocate the purchase price according to relative 
fair market values of the assets acquired. Further, although the court held that 
the right to participate in receipts from television contracts could not be de- 
preciated since it "had no definite limited useful life the duration of which could 
be a.scertained with reasonable accuracy", the court relied u]X)n the existing 4- 
year contract in valuing this right for purposf^s of all ocsi ting the purchase p'rice. 
Concern has been expressed as to whether, if the television contract had only 1 
year left at the time of acquisition, the court would have determined the con- 
tract's value to be the present value of the right to receive television receipts 
for only 1 year. 



97 

The following table illustrates the allocation made of initial team 
acquisition costs by professional basketball teams. 

Allocation oi cost oi teams between iranchise and player contracts 
[In thousands of dollars] 



Club 



Total cost Franchise 



Players 

Player as percent 

contracts of total 



Al 250 

A2 985 

A3 C) 

A4 295 

A5 1,550 

A6 452 

A7 20 

A8 606 

A9 800 

AlO 255 

All 106 

ABA total--. 

Nl 

N2 

N3 

N4 

N5 

N6 

N7 

N8 

N9 

NlO 

Nil ■ 

N12 

N13 

N14 

N15 

N16 

N17 

NBA total 36,073 



250 
100 

C) 

15 
200 
172 

20 

Q) 

425 

255 

6 





885 

i}) 

280 

350 

280 



{') 

373 



100 





89.8 

94.9 

87. 1 

61.9 



46.9 


94.3 



4,713 


1,443 


3,270 


69.4 


500 


250 


250 


50.0 


5, 600 


1, 100 


4,500 


80.4 


5, 175 


1,035 


4, 140 


80.0 


3, 600 


400 


3,200 


88.9 


3, 437 


400 


3,037 


88.4 


1, 250 


50 


1,200 


96.0 


1,016 


416 


600 


59. 1 


678 


200 


478 


70.5 


3, 635 


465 


3,170 


87.2 


1, 157 


101 


1,056 


91.3 


100 


100 








1, 907 


180 


1,727 


90.6 


3, 496 


331 


3,166 


90.5 


25 


25 








3, 040 


50 


2,900 


98.4 


23 





23 


100 


1,434 


150 


1,284 


89.5 



5, 253 30, 821 



85.4 



1 Not available. 

Source: Noll and Okner, "The Economics of Professional Basketball (1971). 

This allocation may result in a tax loss in many cases even where the 
operation of the sports team is generating a positive cash flow. Thus, 
the depreciation claimed by the owner creates tax losses which can be 
used to shelter other income from taxation. 

On the other hand, the seller attempts to allocate most of the aggre- 
gate sales price to franchise rights. In this way, a greater amount of 
any gain is treated as capital gain and a lesser amount is treated as 



69-542 O - 76 - 7 



98 

gain attributable to depreciable assets (e.g., players' contracts) sub- 
ject to recapture as ordinary income. 

With respect to recapture upon sale or disposition of a player con- 
tract, an argument might be made that the recapture rules for de- 
preciable personal property do not apply in light of the past treatment 
of salary contracts by the Internal Kevenue Service. Prior to its 1967 
ruling, the Service treated payments made under a salary contract as 
ordinary and necessary business expenses when paid. Further, salary 
expenses which are not capitalized would not be subject to recapture 
as ordinary income under the judicial tax benefit rule. 

Further, the amount of depreciation taken with respect to player 
contracts will not be recaptured in many cases since a substantial num- 
ber of the original players may have retired or been "cut" and replaced 
by a new player. However, in this case, an abandonment loss would be 
claimed for the adjusted basis of the contract for the player in the 
year he retired or was cut. 

An additional concern relates to the useful life that is adopted with 
respect to the players' contracts. Typically, sports franchises adopt an 
average useful life of between three to six years for these contracts. 
The risk of injury to a player is one of the factors that contributes 
to this short life and is akin to obsolescence or exhaustion of any 
other asset. However, it is argued that in many oases, the actual life 
of the more valuable players extends beyond this period. To the extent 
that a large part of the total amount capitalized with respect to play- 
ers' contracts is allocated to players who generally tend to have a 
longer playing life, the amount allocated is deducted more rapidly 
than the actual decline in the usefulness of the player. 

Industry representatives take the position that sports franchises re- 
ceive no special tax deductions (such as accelerated depreciation) and 
that issues respecting the allocation of purchase price among the 
assets of the franchise are no different than the allocation issues aris- 
ing in connection with the purchase and sale of any business. 



9. PREPAID INTEREST 

General 

Since many investors in tax shelters acquire partnership interests 
toward the end of the calendar year, the investors will have not par- 
ticipated in the partnership long enough to generate a large amount of 
ordinary and necessary expenses in tliat year. Therefore, deductions 
for a variety of prepaid expenses have been central to the creation of 
tax losses. 

One of the prepaid expense items widely used by tax shelters gen- 
erally is prepaid interest. This item normally consists of interest on 
the financing which the investors incur when they initially purchase 
the land, apartment building, orchard, cattle, etc. 

Normally, the investors (or the limited partnership or other entity 
which a group of investors has joined) purchase the shelter property 
toward the end of the calendar year. They finance a large portion of 
the purchase price either by borrowing funds from a bank, insurance 
company, or other outlside lender, or by executing a purchase money 
mortgage note to the person who is selling the property to them. 
In a purchase money mortgage, the seller himself in effect 
extends financing to the parties who are buying the property.^ 

Prepaying interest on a debt obligation enables the investors to 
accelerate the deduction of a sometimes disproportionately large 
amount of the interest due over the full time period of the loan. This 
accelerated deduction of a large amount of prepaid interest gives a 
taxpayer the advantage of tax deferral. 

In some cases, the prepayment — which requires a cash outlay — has 
the effect of reducing the taxpayer's cash flow (net of tax savings). In 
such circumstances, as long as the deduction lowers the taxpayer's 
effective tax rate by more than the market rate of interest, the taxpayer 
will find it to his advantage to shelter his income by prepaying inter- 
est. The earlier this deduction can be obtained, the longer the investor 
has use of the funds and thus can earn additional interest on them. 

However, in many tax shelters a deduction for prepaid interest oan 
be generated without adverse cash flow consequences by borrowing 
more money than is needed and promptly repaying the excess as pre- 
paid interest. Thus, for example, a tax shelter operation needing 



^ Often, where the investors desire to prepay interest, the seller will accept a 
lower "purchase price" and a larger amount of interest. Although most sellers 
would ordinarily desire to receive a larger purchase price (capital gain) and less 
interest (ordinary income), many sellers are not adversely affected by receiving 
interest income. For example, some sellers have expiring loss carryovers to 
absorb the interest income. Other sellers are dealers who would realize short-term 
capital gain on the sale in any event ; still other sellers are pension funds, 
charities or other tax-exempt organizations. 

(99) 



100 

$900,000 in borrowings for 5 years at 11 percent interest could borrow 
$1,000,000 at 10 percent interest in December of its first year, and pre- 
pay one year's interest immediately. The economic effect of the 
arrangement is exactly the same as borrowing $900,000 at 11 percent. 
However, the net effect of structuring the transaction as a borrowing 
of $1,000,000 with a $100,000 interest prepayment is the acceleration of 
a $100,000 deduction for 5 years. 

The advantage of prepaying interest is much greater for those indi- 
viduals who receive a large amount of income in a particular year. For 
such individuals, the prepaid interest deduction can be used to shelter 
the income in excess of what would ordinarly be received by them. 
Such a taxpayer will find it to his advantagee to shelter his income 
by means of a prepaid interest deduction so long as the deduction 
lowers his effective tax rate by more than the market rate of 
interest on the amount of cash (net of tax savings) he must put up. 

In general, reductions in the effective rate will accrue principally 
to taxpayers who are in the higher effective tax brackets because the 
percentage tax reduction in those higher marginal tax brackets makes 
the manipulation of income and deductions between taxable years a 
rewarding financial activity. Taxable income and marginal tax rates 
at the lower end of the progressive tax structure do not yield signifi- 
cant enough financial returns to warrant this type of tax manipulation. 

Cash method of accounting. — The cash method of accounting is 
especially important to investors who want to prepay interest (and 
other expenses). As is the case with certain other expenses suited to 
producing accelerated tax losses, under the cash method, interest ex- 
pense can generally be deducted when it is paid (regardless, of the 
period to which the liability relates). Under the accrual method of 
accounting, by contrast, interest is deductible as it accrues, regardless 
of when the interest expense is paid. The accrual method generally 
achieves a better matching of income and expense than does the cash 
method. 

Present law generally provides that a taxpayer may claim deduc- 
tions in the year which is proper under the method of accounting which 
he uses in computing his taxable income (sec. 461). However, the in- 
come tax regulations provide that even under the cash method of 
accounting, an expense which results in creating an asset having a use- 
ful life which extends substantially beyond the close of the taxable 
year may be deducted only in part in the year in which payment is 
made. Consistent with this rule, the statute provides that if the tax- 
payer's method of accounting does not clearly reflect income, the 
Internal Revenue Service may recompute the income using the method 
which the Service believes does clearly reflect income. 

Until the late 1960s tax-oriented investors were able to prepay as 
much as 5 years' interest with apparent approval by the Service. No 
specific statutory provision expressly permits prepaid interest to be 
deducted as paid by a cash method taxpayer. The authority for deduct- 
ing prepaid interest rests on court cases and on administrative rulings 
by the Internal Revenue Service. In 1968, however, the Service issued 
a revenue ruling providing that prepaid interest can be deducted in 
advance only for a period not in excess of 12 months following the 
taxable year in which the payment is made, and even then, only if the 
deduction does not materially distort income. 



101 

Administrative Rulings 

In Rev. Rul. 68-643, 1968-2 C.B. 76, the Service took the position 
that a deduction of prepaid interest by a cash basis taxpayer will be 
disallowed as materially distorting income except in certain limited 
circumstances. Prepayment for a period extending for more than 12 
months beyond the end of the current taxable year will be deemed to 
create a material distortion of income. In such a case the interest will 
be allocated over the taxable years involved. 

Deductions for interest paid in advance for a period not in excess 
of 12 months after the last day of the taxable year of payment will be 
considered on a case-by-case basis to determine whether a material 
distortion of income has resulted. 

The ruling sets forth several factors which (among others) may be 
considered in determining whether there is a material distortion of in- 
come : the amount of the taxpayer's income in the taxable year of pay- 
ment; his income in previous years; the amount of prepaid interest; 
the time of payment ; the reason for the prepayment ; and the presence 
of a varying rate of interest over the term of the loan.^ Two recent 
court decisions have upheld the Service's application of these criteria 
to particular interest prepayments.^ 

Items rel-ated to prepaid interest 

Points. — It is important under present law to distinguish between 
"points," which are viewed as additional interest charges, and service 
charges such as those which a lender renders in the course of process- 
ing a loan application. In some situations, service charges are treated 
for tax purposes as nondeductible capital expenditures (rather than as 
deductible interest or as ordinary and necessary business expenses). 
In general, the determination of whether points or loan processing 
fees are deductible when paid depends on the facts of the particular 
situation, and the Service has published several rulings indicating 
whether particular payments of this kind are deductible in full when 
paid. 

Loan commitment fees. — Often a bank or other commercial lender 
charges a fee for agreeing to make a loan in the future if and when 
a borrower desires to borrow the funds. Ordinarily, this fee is not 
interest since it does not relate to a borrower's use of money. In some 
cases, however, the payment of the fee has been treated as an ordinary 
and necessary business expense deduction. 

Prepayment penalties. — Generally, penalties for liquidating the 
principal amount of a mortgage or other loan before its due date are 
deductible by the payor as interest. 

- The Service has not made clear whether these criteria apply, in the case of 
a partnership, solely at the pamership level or solely to each partner or possibly 
at both levels. 

^(?. Douglas Bnrck v. Commissioner, — F. 2d — . 76-1 U.S.T.O. par. 9283 (2d 
Cir. 1976), affg. 63 T.C. ."56 (197.'>) (one year's interest on a 27-month loan 
preoaid on December 29 : ^-asih method taxpayer realized an unnsnallv large capi- 
tal gain during the year ; a $377.0(X) prepavment reduced his taxable income from 
.$419,000 to $^1,400: the court allowed onlv 3/365 of interest in the year of pay- 
ment) : Anflrew A. Candor, 62 T.C. "^69 (1974) (5 years' prepaid interest intended 
to shelter unusiiallv high capital gains during year held not deductible at all in 
the year of payment by a cash method taxpayer) . 



102 

Loom discount. — In this type of arrangement the bank (or other 
lender) delivers to the borrower an amount which is smaller than the 
face amount of the loan. The difference is the charge for the debtor's 
use of the borrowed funds. Generally, the borrower cannot deduct the 
amount withheld in the year he receives the loan proceeds ; instead, he 
can deduct the "discount" only over the term of the loan as he pays 
the face amount of the loan. (Rev. Rul. 75-12, 1975-2 I.E.B. 6.) 

Wraparound Mortgage 

A recent technique used to justify larger amounts of prepaid interest 
within the Service's present guidelines than can be obtained under 
conventional financing is the "wraparound mortgage." A wraparound 
mortgage works as follows : Typically, the farm, shopping center, or 
other property which the shelter-minded investors are purchasing is 
encumbered by an existing first mortgage. The investor executes to the 
seller a new purchase money obligation whose face amount includes 
both the unpaid balance of the first mortgage and the new financing 
supplied by the seller (which would ordinarily take the form of a 
-second mortgage) . 

The buyers agree to pay (and to prepay) interest on the face 
amount of the wraparound note, while the seller agrees to continue 
paying the interest on the first mortgage (out of the interest pay- 
ments which he receives from the buyers). In some cases the addi- 
tional prepaid interest which the buyer claims on the wraparound 
note is negotiated as a substitute for a larger down payment by the 
buyers, thereby increasing the deductible portion of the initial pay- 
ments which they make to the seller. Since a wraparound mortgage 
usually bears a higher rate of interest than the first mortgage, the 
seller is motivated to use a wraparound mortgage because he is re- 
lending the balance of the first mortgage to the investor at a higher 
rate of interest than he pays his lender. Thus, the amount received 
as a result of the difference between the interest rates is additional 
profit to him. 

To illustrate how a wraparound mortgage works, assume that the 
sale price of an existing apartment building which a group of inves- 
tors desires to buy at the end of 1975 is $1,500,000, and that there is 
an existing 7 percent first mortgage on the property, the unpaid bal- 
ance of which is $1 million. 

Conventional financing. — Under conventional terms, the buyers 
might pay $100,000 cash down, take the property subject to the exist- 
ing first mortgage, and agree to a $400,000 second mortgage at a 9 
percent interest rate. The investors would agree to pay interest and 
principal on the existing first mortgage. However, without the per- 
mission of the lender of the first mortgage, the buyer/investors cannot 
prepay interest in 1975 on the first mortgage. They could, however, 
agree with the seller to prepay interest on the new financing extended 
by the seller under the second^mortgage. The seller would then receive 
a total of $136,000 in the voar of sale, as follows : 



103 

G onventional -financing — Purchase price : $1^500p00 

Seller Buyers (syndicate) 

Pay: 

Existing 1st mortgage' (7 percent), Cash down payment $100,000 

unpaid balance $1 million. 1st mortgage ( taken sub- 
ject to) 1,000,000 

2d mortgage ( 9 percent ) _ 400, 000 

Total 1,500,000 

Cash flow : Total paid by buyers : 

$136,000 received from buyers and Down payment — 1975___ 100,000 

retained. Prepaid interest (1 year 

on 2d mortgage— 1975— 36,000 

Total 136,000 

Interest paid by buyers 
on 1st mortgage— 1976 70, 000 

Total 206,000 

Under this type of conventional financing, the investors would 
probably claim prepaid interest deductions for 1975 in the amount 
of $36,000. 

'Wraparound technique. — Using the wraparound mortgage tech- 
nique, the investors might make a down payment of $66,000 and 
execute to the seller a mortgage for $1.4 million at 7 percent. (The 
face amount of the new obligation executed by the investors includes, 
or "wraps around," the existing first mortgage on the property.) 
The buyers then prepay one year's interest on the face amount of 
the wraparound mortgage, or $98,000 (7 percent of $1.4 million). 
They might also pay the seller three points on the wraparound mort- 
gage, or $42,000. The seller would agree to continue to be responsible 
for making payments on the first mortgage. (In the following year, 
the seller would therefore pav $70,000 to the lender on the first mort- 
gage, and retain a net of $136,000.) 

The wraparound mortgage can be described as follows : 

Wraparound mortgage — Purchase price: $l.Ji66fX)0 

Seller Buyers (syndicate) 
Pay: 

$1,000,000 mortgage (seller will con- Cash down payment $66,000 

tinue to discharge out of payments PxT-^^tiaQ T^i^np- mort- 

he receives from the buyers). gage (wraparound) 7 

Cashflow: percent 1,400,000 

Received from Buyers — ■ 

1975 $206,000 Total 1,466,000 

Less : Interest due on 1st Three poin'ts on new 

mortgage 1976 70, 000 mortgage 42, 000 

Retained by seller— 136, 000 Total paid by Buyers— 1975 : 

Down payment 66, 000 

Prepaid interest — 1 year 
on purchase money 

mortgage 98,000 

Three i>oints on new 
mortgage 42, 000 

Total 206,000 



104 

By using this technique, the seller nets the same $136,000 as under 
conventional terms, but the wraparound technique enables the inves- 
tors to claim $140,000 in interest deductions in 1975 (rather than 
$36,000).* 

In this example the total purchase price of the property has been 
reduced from $1.5 million to $1,466,000. The seller nets the same 
amount ($136,000) under either financing method. However, the 
buyers/investors have increased their claim to deduct one year's pre- 
paid interest from $36,000 to $98,000. They have also paid points on 
the face of the wraparound mortgage which gives the seller the same 
doillar amount ($136,000) which he would have received under con- 
ventional financing and also gives the investors an additional interest 
deduction. The investors have in effect prepaid interest on the first 
mortgage without obtaining the lender's permission to do so. They 
have also converted $34,000 of purchase price dollars, if conventional 
financing had been used) into deductible interest dollars. 

Recently, the Service has taken an administrative position indicat- 
ing that it will measure the permissible prepaid interest deduction 
(under the tests of Rev. Rul. 68-643) not by reference to the face 
amount of the wraparound note but only by reference to the new 
credit which the seller extends to the buyer. ^ 

Operation of Shelter 

The effect of denying deductions for interest which is prepaid by a 
cash method taxpayer is to place that taxpayer on the accrual method 
as to a single item of his income and expense (but not as to other items) . 
However, critics of this treatment of prepaid interest point out that the 
rationale for denying the deductions goes beyond the concept that cash 
basis taxpayers cannot deduct payments of expenses whose benefit (use 
of money, in this case) will be realized beyond the current year. The 
cash method, it is argued, inherently departs from good accounting 
principles (matching of income and expenses, etc.) , but has been per- 
mitted for reasons of convenience and ease of bookkeeping. In this 
view, a "clear reflection of income" test cannot logically be applied to 
only one item on a cash basis taxpayer's return since almost always he 
would report the expense differently if his return were prepared on 

* Typically, in lieu of having the investors pay i)Oints to the seller, the interest 
rate on the wraparound is higher than the existing interest rate on the first 
mortgage. In this example, the interest rate on the $1,400,000 wraparound mort- 
gage would likely to be higher than the presumably lower interest rate on the first 
mortgage. In such cases, the seller would retain (and profit from) the increased 
interest amounts on the first mortgage which the investors will pay to him but 
which he will not have to pay over to the lender on the first mortgage. 

^In Rev. Rul. 75-99, 1975-12 I.R.B. 14, a party owning real estate encum- 
bered by a $300x first mortgage (7 percent) executed a note to a real estate 
investment trust in the amount of $400x at 8 percent per year. The trust ad- 
vanced $100x to the borrower. The trust also agreed to make the periodic prin- 
cipal and interest payments on the first mortgage. The ruling holds that the 
indebtedness betwen the trust and the borrower giving rise to an obligation to 
pay interest to the trust is not the face amount of the wraparound note, but 
only the $100x "actually" loaned by the trust. Payments by the trust on the first 
mortgage were considered made on behalf of the borrower. 



105 

the accrual method on accounting.*' On the other hand, it is argued that 
prepaid interest, like prepaid rent and prepaid insurance, is an expen- 
diture which results in the creation of an asset having a useful life 
which extends substantially beyond the close of the taxable ^ear. If so, 
even under the cash method of accounting, prepaid interest is properly 
deductible no earlier than over the period to which it relates. This ra- 
tionale has been applied to prepaid (or advance) rentals and prepaid 
insurance ^ even though requiring prepaid rent or prepaid insurance 
premiums to be deducted no earlier than over the period to which they 
relate arguably puts a cash method taxpayer on an accrual method for 
such items. 

Critics of the Service's ruling tests for prepaid interest also object to 
a "case by case" approach to determine deductions. They argue that 
the deduction by the same taxpayer of prepaid interest should not be 
allowed in one year and perhaps not in another year. Nor should pre- 
paid interest be deductible by one taxpayer who has a large amount 
of income in a given year after the deduction (so that the deduction 
does not "distort" his income) but possibly not be deductible by an- 
other taxpayer who has little or no taxable income after taking the 
deduction.* 



* Some critics have also contended that a prepayment of interest in order to off- 
set a nonrecurring or "one-shot" increase in income during a year should not be 
regarded as distorting income because the deduction, in effect, levels out his 
income. 

• voinmissioner v. Boylston Market Ass'n, 131 F.2d 966 (1st Cir. 1&42) (prepaid 
insurance) ; Norman Baker Smith, 51 T.C. 429 (1968) (prepaid rent) ; University 
Properties Inc., 45 T.C. 416, 421 (1966), aff'd, 387 F.2d 83 (9th Cir. 1967) (pre- 
paid rent) ; Martha R. Peters, 4 T.C. 1236 (prepaid insurance) ; Rev. Rul. 70-413, 
1970-2 C.B. 103 (prepaid insurance) ; contra, Waldheim Realty d Inv. Co. v. Com- 
mis.noner, 245 F.2d 823 (8th Cir. 1957). 

' Some commentators who have analyzed the Service's tests and the case law 
believe that the rule of present law is, in effect, that the Commissioner can place 
cash method taxpayers on the accrual method as to prepaid interest if a deduction 
under the cash method causes a great (rather than merely some) disparity be- 
tween taxable income as computed on the cash method and as computed on the 
accrual method. 



10. PARTNERSHIP PROVISIONS 

General 

The form of entity most commonly chosen to maximize tax benefits 
in a tax shelter investment has been the limited partnership, which, 
upon meeting certain requirements, is subject to both the general 
partnership provisions and certain provisions of the income tax 
regulations having particular application to limited partnerships. A 
limited partner is a passive investor who is not personally liable for 
any more than his equity contribution to the partnership (plus his 
agreed future contributions), even though he may benefit by certain 
partnership provisions allowing him to deduct losses in excess of that 
contribution. 

Under the partnership provisions of the Internal Revenue Code 
(sees. 701-771), a partnership is generally treated as an entity for 
accounting purposes and treated as a conduit for taxpaying purposes. 
It is an entity for purposes of calculating taxable income and many 
particular items of income, deduction, and credit (sec. 703). It is also 
an entity for purposes of reporting information to the Internal Reve- 
nue Service (sec. 6031) . 

A partnership is a conduit for purposes of income tax liability and 
payment. Each partner takes into income his own "distributive share" 
of the partnership's taxable income and the separately allocable items 
of income, deduction, and credit (sec. 702(a) ). The liability for income 
tax payment is that of the partner, and not of the partnership (sec. 
701). Thus, that income is taxed at only one level — the partner's level 
(as distinguished from the corporation, where income is taxed at 
the corporate level and dividends are taxed at the shareholder level ^) . 
This means that the partner is taxed on the partnership profits even 
though none of these profits may be distributed to the partner. 

Partnership losses, deductions, and credits pass throush _ to the 
partner and can be used to offset other income, therebv reducing the 
income tax liability of the partner. The amount of losses which a 
partner may deduct under these provisions for a particular year is 
not to exceed the amount of the adjusted basis of his partnership 
interest (sec. 704 (d)), which, at the inception of the partnership, 
equals the sum of his capital contribution to the partnership plus his 
share, if any, of partnership liabilities. "With respect to limited part- 
nerships, the Treasurv Re.ofulations (§ 1.752-1 (e) ) provide that a 
limited partner's share of the partnership's liabilities includes a pro 



^Electing small busimess corporations (subchapter S corporations) are taxed 
in a manner roughly similar to partnerships ; a number of the relevant elements 
of this treatment are discussed below. 

(107) 



108 

rata share (the same proportion in which he shares profits) of all 
liabilities with respect to which there is no personal liability ("non- 
recourse liability"). (See Nonrecourse Loans, under IRS Rulings 
Policy, below, for an explanation of the impact of this provision of 
the Treasury Regulations.) 

Subject to the restriction that its purpose is not to avoid or evade 
tax, a limited or general partnership agreement may provide for the 
manner in which the partnership's items of income, gain, loss, deduc- 
tion, or credit will be allocated among the partners (sec. 70i). 

Qualification for Partnership Tax Status 

The Treasury Regulations (§§301.7701-2 and 301.7701-3) provide 
that, in order to qualify for the partnership tax treatment described 
above, a limited partnership must be lacking in at least two of the 
following four characteristics peculiar to corporations: (1) centrali- 
zation of management, (2) continuity of life, (3) free transferability 
of interest, and (4) limited liability. If the limited partnership is not 
lacking in at least two of these corporate characteristics (or, put an- 
other way, if at least three of the four corporate characteristics are 
present) , it will be subject to tax treatment as a corporation, one major 
consequence of which is to preclude the passthrough of the tax shelter 
losses to the investors. Thus, it is of crucial importance for tax shelter 
purposes that the limited partnership have fewer than three of the 
four corporate characteristics so that its partners can deduct its tax 
shelter losses. 

Centralization of Management 
In the context of a limited partnership, centralization of manage- 
ment exists if substantially all of the interests in the parttnership are 
owned by the liinited partners. "\^^iile the Internal Revenue Service 
disavows any mechanical test for advance ruling purposes, the staff 
understands that if the general partners in the aggregate have a 20- 
percent or greater interest in the partnership capital obtained through 
capital contributions, the limited partnei^hip will be treated as lack- 
ing the corporate characteristic of centralization of management. In 
most limited partnerships, the general partner does not have a 20-per- 
cent interest in capital, 'and for planning purposes, this characteristic 
generally is considered to be present. 

Continuity of Life 
The regulations provide three distinct situations by which a limited 
partnership would be lacking in the corporate characteristic of con- 
tinuity of life : 

1. if the bankruptcy, dissolution, retirement, resignation, death, 
insanity, or expulsion of a general partner causes 'a dissolution 
of the partnership (even though the partnership would not be 
dissolved if the remaining general partners or all remaining 
partners agree to continue the partnership) ; 

2. if a general partner has the power at any time to dissolve 
the partnership ; or 



109 

3. if the partnership is formed pursuant to a State statute corre- 
sponding to the Uniform Limited Partnership Act.^ 

Free Transferability of Interest 
Most limited partnerships encomiter little difficulty in negating the 
characteristic of free transferability of interest. This characteristic 
relates exclusively to the ability of a limited partner to make another 
person a substitute limited partner. Thus, notwithstanding a limited 
partner's right to assign profits and losses, free transferability can be 
negated simply by providing that no assignee of a limited partner may 
become a substitute limited partner without the prior consent of the 
general partners. In the tax shelter area, general partners normally 
consent to such substitutions. 

Limited Liability 
In the context of a limited partnership, the characteristic of limited 
liability is not present if the general partner has substantial assets 
(other than the interest in the partnership) which can be reached by 
a creditor or if the general partner is not a "dummy" acting as an 
agent of the limited partners. 

IRS Rulings Policy 

Limited Liability — Net Worth Test 
In connection with the characteristic of limited liability, the Service 
has set forth certain net worth requirements which must be met by 
a corporation serving as the sole general partner of a limited partner- 
ship before the Service will consider issuing an advance ruling classi- 
fying the limited partnership as a partnership for Federal tax pur- 
poses (Rev. Proc. 72-13, 1972^1 C.B. 735). The Service requires a 
net worth, based on a current fair market value test, equal to the sum 
of 10 percent or 15 percent of the capital raised in the partnership, 
the percentage depending upon the amount of capital raised : 

1. if the capital raised is less than $1,666,667, the net worth of 
the corporate general partner must be at least 15 percent of the 
capital ; 

2. if the capital raised is between $1,666,667 and $2,500,000, the 
net worth of the corporate general partner must be at least 
$250,000; and 

3. if the capital raised exceeds $2,500,000, the net worth of the 
corporate general partner must be at least 10 percent of the 
capital. 

In calculating net worth, the corporation's interest in the limited 
partnership and receivables to and from the limited partnership are 
excluded. 

Rules also are provided for cases where the corporate general part- 
ner has interests in more than one limited partnership. 

" In 1973 and again in 1974, California amended a section of its version of the 
Uniform Limited Partnership Act to conform with the corresponding section of 
the Uniform Limited Partnership Act. Seemingly, the sole purpose of these con- 
forming amendments was to facilitate California limited partnerships negating 
the corporate characteristic of continuity of life. See Rev. Rul. 74-320, 1974-2 
C.B. 404, and Announcement 75-23, 1975-11 C.B. 87, ruling that those amend- 
ments resulted in the negation of the characteristic of continuity of life. 



no 

Common Oionership of Corjyorate General Partner 
In addition to its net worth requirements, the Service has estab- 
lished (Rev. Proc. 72-13, supra) certain other restrictions with regard 
to the percentage of stock ownership that the limited partners may 
have in a sole corporate general partner. Thus, an advance ruling will 
not be issued if the limited partners directly or indirectly own more 
than 20 percent of the stock of the corporate general partner or its 
affiliates. Moreover, the Service will not issue an advance ruling if the 
purchase of a limited partnership interest by a limited partner would 
entail either a mandatory or discretionary purchase or option to pur- 
chase any type of security of the corporate general partner or its 
affiliates. Seemingly, the purpose of these restrictions is to prevent a 
substantial identity of interest in the corporate general partner and the 
limited partnership.^ 

Principal Purpose of Avoidance of Federal Taxes 
In Rev. Proc. 74-17, 1974-1 C.B. 438, the Service set forth its position 
that it will not issue an advance ruling where factual questions are 
raised as to whether the principal purpose of the limited partnership's 
formation is the reduction of Federal taxes. The following operating 
rules ordinarily must be complied with in order for the Service to be 
willing to issue an advance ruling that a limited partnership is a 
partnership under the Internal Revenue Code : 

(1) At all times during the existence of the partnership, the 
general partners, taken together, must have at least a one-percent 
interest in each material item of partnership income, gain, loss, 
deduction, or credit. 

(2) For the first two years of operation of the limited partner- 
ship, the partners may not claim aggregate deductions which 
exceed the amount of equity capital invested in the limited part- 
nership. This requirement generally precludes the use of non- 
recourse liability included in the partners' adjusted bases to absorb 
losses incurred during the first two years of operation. 

(3) Any creditor who has made a nonrecourse loan to the limited 
partnership must not have or acquire at any time, as a result of 
that loan, any direct or indirect interest, other than as a secured 
creditor, in the profits, capital or property of the partnership. 

Syndication and Organization Fees 
Until recently, it has been the common practice for limited partner- 
ships to deduct the payments made to the general partner for the serv- 
ices he rendered in connection with the syndication and organization 
of the limited partnership. In Rev. Rul. 75-214 (1975-23 I.R.B. 9) , the 
Service ruled that such payments to general partners for services 

" The most extreme case of this situation would be where the corporation is 
wholly owned by all the limited partners in proportion to their partnership inter- 
ests. A persuasive argument could be made here that, in substance, the sharehold- 
ers of the corporation were conducting coi-porate business through a limited part- 
nership while having essentially the same rights and obligations had the business 
been operated directly by the corporation. The Service apparently believes that 
the danger of substantial identity of interest is too great to be acceptable when- 
ever the limited partners' ownership of stock in the corporate general partner is 
greater than 20 percent. 



Ill 

rendered in organizing and syndicating a partnership constitute 
capital expenditures which are not currently deductible."* 

Nonrecourse Loans 

Commonly, the equity contributions of limited partners do not ade- 
quately capitalize the operations of a limited partnership. The addi- 
tional capital frequently is obtained by borrowing, using partnership 
property as security, without the limited partnership or its partners 
incurring any personal liability with respect to that borrowing. The 
loans obtained by the limited partnership provide "leverage" by mak- 
ing it possible for a partner to deduct tax losses in excess of his equity 
contribution to the partnership. 

A limited partner may deduct from his personal income all the 
deductible items of the partnership which are allocated to him under 
the partnership agreement, but not more than the amount of his basis 
for his interest in the partnership, which is reduced by the amount of 
the deductions as they are taken. 

In general, at the inception of the partnership, a limited partner's 
basis for his interest equals the sum of his capital contribution plus 
his share, if any, of partnership liabilities. Under the Treasury's in- 
come tax regulations (§ 1.752-1 (e) ) , "where none of the partners have 
any personal liability with respect to partnership liability (as in the 
case of a mortgage on real estate acquired by the partnership without 
the assumption by the partnership or any of the partners of any liabil- 
ity on the mortgage), then all partners, including limited partners, 
shall be considered as sharing such liability under section 752(c) in 
the same proportion as they share the profits." ^ Through the use of 
this device, a limited partner may obtain a substantial increase in his 
basis, and, thus, in the amount of losses he may deduct. 

For example, if a limited partner pays $10,000 for a 5 percent in- 
terest in the capital and profits and losses of a limited partnership 
which obtains a nonrecourse loan of $500,000, the limited partner's 
basis in his interest would be $35,000 ($10,000 plus 5% of $500,000). 
Thus, as a result of "leveraging", the limited partner may be able to 
deduct an amount far exceeding that of his actual investment.® 



- In a recent case involving a related situation, the United States Tax Court 
disallowed the deductions for certain payments made to a general partner. Jack- 
son E. Cagle, Jr., 63 T.C. 86 (1974), on appeal to C.A. 5 (payment for services 
rendered for conducting a feasibility study of a proposed office-showroom facility, 
obtaining financing, and developing a building for the partnership) . 

^ This rule has been justified as an adaptation to the limited partnership situa- 
tion of a principle set forth by the United States Supreme Court in Crane v. Com- 
missioner, 331 U.'S. 1 (1947). 

* Where a lender requires that the general partner be personally liable on a 
loan (such as a construction loan), some limited partnerships have attempted to 
create basis for each of the limited partners by providing for contingent con- 
tributions ; i.e., the limited partners are obligated to make certain additional con- 
tributions if they are called for by the general partner. The rights to call for the 
additional contributions commonly would expire upon the obtaining of nonre- 
course financing and, in some cases, there may well have been no intention to 
call for such additional contributions. The intended effect of this arrangement 
is to provide the same increase in the limited partners' bases for their partnership 
interests (hence, the same increase in the ceiling for tax shelter deductions) as 
would have been the case if the general partner had not been made personally 
liable on the loan. 



112 

It should be noted that while the nonrecourse loan rule may permit 
an investor to take deductions exceeding his initial investment, this I* 
rule can also result in the subsequent recognition by the investor of 
substantial amounts of both ordinary and capital gain income where 
either the partnership sells or otherwise disposes of the partnership 
property that secures the nonrecourse loan or a limited partner sells 
or otherwise disposes of his partnership interest." 

Sometimes the gain recognized in these situations is referred to as 
"phantom gain" due to the fact that the sale or disposition generates 
little or no cash (such as in a mortgage foreclosure, which is treated as | 
taxable disposition of the property), but does result in a gain with 
respect to which substantial tax liability is created. In other words, in 
such a case, the taxpayer is required to repay part or all of his interest- 
free loan from the Government (the earlier savings from the tax shel- 
ter) , which to a great extent was generated by nonrecourse borrowings. 

In 1972, the Service issued two rulings involving nonrecourse loans. 
While both rulings dealt with and have particular application to 
limited partnerships engaged in oil and gas exploration, they are 
susceptible to a much broader application. In Rev. Rul. 72-135, 
1972-1 C.B. 200, the Service ruled that a nonrecourse loan from the 
general partner to a limited partner, or from the general partner to 
the partnership, would constitute a contribution to the capital of the 
partnership by the general partner, and not a loan, thereby precluding 
an increase in the basis of the limited partner's partnership interest 
with respect to any portion of such a loan. In Rev. Rul. 72-350, 1972-2 
C.B. 394, the Service ruled that a nonrecourse loan by a nonpartner to 
the limited partnership, which was secured by highly speculative and 
relatively low value property of the partnership, and whicli was 
convertible into a 25 percent interest in the partnership's profits, did 
not constitute a bona fide debt, but was, in reality, equity capital placed 
at the risk of the partnership's business. This, too, would preclude 
increases in the bases of the limited partner's interests. 

Partnership Allocations 

Special A Uocations 
Under the partnership provisions, a limited (or a general) partner- 
ship agreement may allocate "any item of income, gain, loss, deduc- 
tion, or credit among the partners in a manner that is disproportionate 
to the capital contributions of such partners (sec. 704:(a), (b)(1)). 
These are sometimes referred to as "special allocations" and, with 
respect to any taxable year, may be made by amendment to the part- 
nership agreement at any time up to the initial due date of the part- 
nership tax return for that year (sec. 761 (c) ) . 

' In general, in computing the gains derived upon these sales or dispositions, 
the outstanding principal amount of the nonrecourse loan (which usually is 
at or near its original amount) must be added to the amount received, "and 
will thus increase the amount of gain to be recognized. Because the partner- 
ship property or the partner's partnership interest may at that time have a 
very low liasis (because of such previous claimed accelerated deductions as 
depreciation), the recognizable gain may be sizeable in amount. Under the 
partnership tax law (.sec. 7.")1) there may be a recapture of certain accelerated 
deductions and, consequently, there may be recognition of ordinary income. 



113 

Special allocations of profits, losses, income items, and deductions 
may be used to combine tax-oriented and nontax-oriented investors in 
a single partnership. Typically, the tax benefits and large portions of 
the capital appreciation on resale are given to the high-income investor, 
while greater security and first return of cashflow are given to the 
nontax-oriented investor. 

A special allocation will not be recognized if its principal purpose 
is to avoid or evade a Federal tax (sec. 704(b) (2) ). In determining 
whether a special allocation has been made principally for the avoid- 
ance of income tax, the regulations focus upon whether the special 
allocation has "substantial economic effect," that is, whether the alloca- 
tion may actually affect the dollar amount of the partner's share of the 
total partnership income or loss independently of tax consequences 
(Regs. § 1.704-1 (b) (2)). The regulations also inquire as to whether 
there was a business purpose for this special allocation, whether related 
items from the same source are subject to the same allocation, whether 
the allocation ignored normal business factors and was made after the 
amount of the specially allocated item could reasonably be estimated, 
the duration of the allocation, and the overall tax consequences of the 
allocation. 

A primary case dealing with this issue, Stanley C. Ornsch^ 55 T.C. 
395 (1970), affirmed C.A. 9, disallowed a deduction of 100 percent of 
the depreciation by one of the partners in a two-man partnership. The 
allocation in this case was found to have been made for the principal 
purpose of evading or avoiding income tax, the parties failing to dem- 
onstrate any economic effect of the allocation. The court indicated that 
the taxpayer had not shown that he had borne the risk of economic 
depreciation of the property in question. 

In the case of Leon A. Harris^ 61 T.C. 770 ,(1974) , the United States 
Tax Court sustained the special allocation to a partner of a loss sus- 
tained upon the sale of an interest in a shopping center, where the 
entire sales proceeds were distributed to that partner and his capital 
account was charged with the entire loss on the sale. 

More recently, the Service announced (Rev. Proc. 74-22, 1974-2 
C.B. 476) that it would not issue advance rulings as to whether the 
principal purpose of a special allocation is the avoidance or evasion 
of Federal income tax. 

Retroactive Allocations 

Investments in tax shelter limited partnerships are commonly made 
toward the end of the taxable year. It is also common for the limited 
partnership to have been formed earlier in the year on a skeletal basis 
with one general partner and a so-called "dummy" limited partner. 
In many cases the limited partnership incurs substantial deductible 
expenses prior to the year-end entry of the limited partner-investors. 

In these tax shelter limited partnerships, the limited partnership 
usually allocates a full share of the partnership losses for the entire 
year to those limited partners joining at the close of the taxable year. 
These are referred to as "retroactive allocations." For example, in the 
case of a limited partnership owning an apartment house which has 
been under construction for a substantial part of the year, where con- 
struction interest and certain deductible taxes have been paid during 



69-542 O - 76 - 8 



114 

that time, such deductions might be retroactively allocated to in- 
vestors entering the partnership on, say, December 28th of that year. 

There has been much debate about whether a retroactive allocation 
of loss is permissible under the Internal Revenue Code. Different 
commentors have interpreted the partnership provisions of the Code 
to both support and reject retroactive allocations.^ 

Three cases, dealing directly or indirectly with this issue, provide 
some support for retroactive allocations. Smith v. Commissioner^ 
331 F.2d 298 (C.A. 7, 1964) (retroactive allocation allowed for lack 
of finding of purpose to avoid tax) ; Jean V. Kresser, 54 T.C. 1621 
(1970) (retroactive allocation disallowed for failure to modify the 
partnership agreement, but the court indicated that if the agree- 
ment had been so modified, the allocation would have been sustained, 
notwithstanding its recognition of avoidance of tax as a principal 
purpose) ; and Norman A. Rodman, 32 T.C.M. 1307 (1973) (retro- 
active allocation of profits, as argued by the Government, sustained). 

Partnership Additional First- Year Depreciation 

An owner of tangible personal property is eligible to elect, for the 
first year the property is depreciated, a deduction for additional first- 
year depreciation of 20 percent of the cost of the property (sec. 179). 
The cost of the propertv on which this "bonus" depreciation is calcu- 
lated is not to exceed $10,000 ($20,000 for an individual who files a 
joint return). The maximum bonus depreciation deduction is thus 
limited to $2,000 ($4,000 for an individual filing a joint return) . Bonus 
depreciation is available only for property that has a useful life of six 
years or more. 

"Where the owner is a partnership, the election for bonus deprecia- 
tion is made by the partnership. However, the dollar limitation de- 
scribed above is applied to the individual partners rather than to the 
partnership entity. For example, each one of 40 individual investors 
who contributed $5,000 to an equipment leasing limited partnership, 
which purchased a $1 million executive aircraft on a leveraged basis, 
would be entitled to $4,000 of bonus depreciation if he filed a joint 
return. In this case, additional first-year depreciation would provide 
total deductions to the partners of $160,000.-' 

A corporation, however, is allowed to deduct only $2,000 in addi- 
tional first-year depreciation. Thus, in the case of the purchase of an 
aircraft, as described above, a corporation would be limited to $2,000 



®Read in conjunction with each other, sections 704(a) and 761(c) would seem 
to support retroactive allocations. Some would interpret section 704(b)(2), 
which prohibits an allocation having tax avoidance as its principal purpose, 
as being inapplicable to allocations of net profit and loss, as opposed to an allo- 
cation of a particular item of income or loss. Others arrive at the opposite 
interpretation of this provision. Yet another partnership provision, section 706 
(c)(2)(B), is proffered by many as the provision which would restrict a 
partner's losses to those incurred in that part of the year during which that 
person was a partner. Here again, there are contrary interpretations hy other 
tax experts. 

"The additional first-year depreciation reduces the depreciable basis of the 
equipment. However, the partnership is still entitled to claim (and the partners 
to deduct) accelerated depreciation on the reduced basis in the property both for 
the first year and for the later years of the property's useful life. 



115 

in additional first-year depreciation, whereas the partnership would 
pass through to the partners total first-year additional depreciation of 
$160,000. 

Issues 

Questions have been directed to the provision of the income tax regu- 
lations (§ 1.752-1 (e) ), which allows a limited partner to increase the 
basis in his investment, and therefore the amount of losses that he may 
deduct, by a portion of nonrecourse indebtedness. Under this regula- 
tion, the investors are able to use borrowed funds with respect to which 
they have no personal liability to generate deductions in amounts 
larger than what they have at risk in the limited partnership. On the 
other hand, it has been argued that this provision of the income tax 
regulations applying to limited partners is no more than an adaption 
of the principle of a Supreme Court case ^° where nonrecourse in- 
debtedness, regardless of the form of business involved, is added to the 
owner's basis of the property. 

Questions have also been raised as to whether syndication and orga- 
nization fees paid by tax-sheltered limited partnerships are in the 
nature of capital expenditvires and should not be deducted. This posi- 
tion has been sustained recently in the courts and in an IRS ruling. 

One of the more significant issues arising under the partnership tax 
provisions concerns the allocation by a limited partnership to a new 
partner of deductions that were incurred or paid prior to the time of 
his entrance into the partnership. The partnership provisions of the 
Internal Revenue Code are unclear as to whether these allocations can 
be made. The consequence of allowing these allocations, essentially, is 
that new limited partners, who ordinarily invest in the partnership 
towards the close of the taxable year, deduct expenses which were 
incurred or paid prior to their entry into the partnership. 

Some argue that these retroactive allocations are proper because 
the funds invested by the new limited partners serve to reimburse the 
original partners for their expenditures (or other deductible items) 
and that, as an economic matter, the new partners have incurred the 
costs for which they are taking deductions. However, this argument 
may lose its persuasiveness when the new investor in a limited partner- 
ship situation is compared to that of an investor who directly pur- 
chases property which had previously generated tax losses during the 
taxable year. It is clear that in the latter case the investor would not be 
entitled to any deductions for the losses incurred prior to his owner- 
ship of the property, notwithstanding the fact that he may, in effect, 
be reimbursing the seller of the property for losses already incurred. 

" Crane v. Commissioner, 331 U.S. 1 (1947) . 



11. HOUSE BILL— LIMITATION ON ARTIFICIAL LOSSES 

(LAL) 

The House bill imposes a limitation, commonly referred to as LAL 
(limitation on artificial losses), on the extent to which losses arising 
from accelerated deductions with respect to certain activities can 
be used to offset a taxpayer's other income. LTnder this limitation, 
specified accelerated deductions are not allowed in the taxable year in 
which such deductions are paid or incurred to the extent they exceed 
a taxpayer's net income from that activity. These deductions are 
to be deferred until either the taxpayer has income from that activity 
in a future taxable year or until he disposes of the property to which 
the accelerated deductions are attributable. In all of these activities, 
the limitation is not to apply to true economic losses which are to con- 
tinue to be deducted currently. The following is a brief description 
of the application of the LAL provision with respect to each of the 
activities to which it applies. 

1. Real estate 

In the case of real estate, all real property would be fully consoli- 
dated for purposes of LAL. The accelerated deductions attributable 
to real property would be deferred in a "deferred deduction account" 
to a later year to the extent that the deductions exceed the taxpayer's 
net related income from real property. Net related income is gross in- 
come from real property less the "ordinary deductions" attributable to 
real property (deductions other than the accelerated deductions). The 
limitation would not apply to true economic losses which would con- 
tinue to be deductible currently. 

The accelerated deductions which would be limited as indicated 
above are the deductions for interest and taxes during the construc- 
tion period, and accelerated depreciation in excess of straight line 
depreciation. 

In general, LAL would apply to commercial and residential prop- 
erty where the construction begins after December 31, 1975. However, 
LAL would not apply to residential real property if {a) before Janu- 
ary 1, 1977, the taxpayer has acquired the site (or has a binding option 
to acquire the site) and there is a firm commitment for the permanent 
financing of the property and if ( & ) construction begins before Janu- 
ary 1, 1978. In addition, LAL would not apply to governmentally sub- 
sidized loAV-income housing if {a) before January 1, 1979, the taxpayer 
acquires a subsidy commitment under section 8 of the United States 
Housing Act of 1937 (or a comparable State or local subsidy commit- 
ment) and if (&) construction begins before January 1, 1981. 

2. Farm, operations 

Accelerated deductions attributable to farm operations would be 
deferred in a "deferred deduction account" to a later year to the ex- 

(117) 



118 

tent that the deductions exceed the taxpayer's net related income from 
±arm operations. Net related income is gross income from farm opera- ^ 
tions less the "ordinary deductions" attributable to farm operations I 
(deductions other than the accelerated deductions). The limitation t 
would not apply to true economic losses which would continue to be de- I 
ductible currently. , 

The accelerated deductions which would be limited as indicated I 
above generally include: (1) preproductive period expenses attrib- I 
utable to crops, animals, trees (or any other property having a crop . 
or yield) but shall not apply to taxes and interest," to any amount \ 
incurred on account of certain casualties, to grain, oil seed, fiber, c 
pasture, tobacco, silage, and forage crops (including expenses of s 
planting, seeding, residue processing, fallowing, plowing, or any other j 
soil preparation), and livestock other than poultry; (2) prepaid feed, 
seed, fertilizer and similar farm supply expenses other than amounts i 
paid for supplies which are on hand on account of certain casualties t 
or amounts paid for feed which is on hand at the close of the taxable c 
year if the taxpayer, on the average, produces more than 50 percent li 
(by volume) of the feed consumed by such taxpayer's livestock; and j 
(3) accelerated depreciation of livestock (or any other property hav- \ 
mg a crop or yield) after they have begun to be productive "in the I 
taxpayer's business. The exclusion from LAL of the preproductive j 
period expenses of grain, oil seed, fiber, pasture, tobacco, silage, and t 
forage crops and livestock other than poultry would not apply to 
farming syndicates. Also, farming syndicates would not have the 
benefit of the exclusion from LAL of prepaid feed expenses for tax- 
payers who grow more than 50 percent of their feed. j^ 

In general, a taxpayer could aggregate all farm operations in ap- 
plying LAL. However, LAL would apply separately for each farm ' 
interest in the case of each farming syndicate or similar offering. ■ 

Losses attributable to accelerated deductions from farm opera- ' 
tions may be used to offset up to $20,000 of nonfarm income. However, ' 
if a taxpayer has nonfarm income in excess of $20,000, the amount of ' 
artificial farm loss allowable as a current deduction from nonfarm 
income would be reduced from $20,000. on a dollar-for-dollar basis. 
for each dollar of nonfarm income in excess of $20,000. Thus, no ' 
artificial farm losses could be taken as deductions currently by tax- 
payers who have nonfarm income of $40,000 or more. Farm income 
would include income from processing where a farmer processes his 
farm products. 

These LAL rules would apply to individuals, estates and trusts, 
and corporations which are excepted from the provision requiring 
certain farm corporations to use the accrual method of accounting 
for their farm operations. However, LAL would not apply to any 
taxpayers who use the accrual method of accounting and who cap- 
italize their preproductive expenses. 

LAL would apply to accelerated deductions paid or incurred after 
December 31, 1975, in taxable years ending after such date, includ- 
ing prepaid supplies purchased, preproductive expenses paid or in- 
curred and accelerated depreciation incurred after that time with 
respect to existing farm operations. However, LAL would not apply 
to that portion of a grove, orchard, or vineyard planted before Septem- 
ber 11, 1975. ' J F F 



119 

3. Oil and gas 

LAL would apply to intangible drilling and development costs on 
developmental oil and gas wells on a property-by-property basis. As a 
result, these deductions could not be taken in any year to the extent 
they exceed the net related income derived in that year from the oper- 
ation of the same property. The amount of the related income (against 
which the intangible drilling costs could be deducted) would be re- 
duced by the amount of any percentage depletion and dry hole deduc- 
tions taken with respect to that income. Any excess deductions would 
be placed in a "deferred deduction account" until such time as the tax- 
payer has income from that property. If not previously deducted, 
expenses attributable to a dry hole would be deductible in full in the 
year in which the dry hole was completed. 

LAL would not apply to intangible drilling and development costs 
incurred in connection with exploratory wells. An exploratory well, 
for these purposes, includes any well which is located at least 2 miles 
from a producing well, and any well which is within the 2-mile limit 
if a measurement of the bottom hole pressure indicates that the Avell 
taps a new, deeper reservoir. A well could also be treated as an explora- 
tory well if the taxpayer can establish to the satisfaction of the lES 
that, under all the facts and circumstances, the well in question has 
tapped a new reservoir from which there has been no production in the 
past. In addition LAL would not apply to water injection wells. 

LAL would apply with respect to costs paid or incurred after 
December 31, 1975. 

4. Movies and similar -property 

LAL would apply to motion picture films and similar property oii 
a property-by-property basis. The accelerated deductions for motion 
picture films and similar productions would not be deducted currently 
to the extent they exceed the taxpayer's income from the film. The 
accelerated deductions to which LAL would apply include deprecia- 
tion or amortization and amounts attributable to producing, distribut- 
ing or displaying a motion picture film or video tape. The inclusion 
of depreciation as an accelerated deduction means that LAL would 
apply to the "film purchase" shelter in which a limited partnership is 
formed to purchase a film and the partners claim a substantial depre- 
ciation deduction in the earlier years. Production costs would be in- 
cluded as an accelerated deduction subject to LAL to deal with the 
problem of the "production company" shelter (in which a limited 
partnership is formed to produce a motion picture and deducts the 
costs of production as they are paid) . 

Costs and expenses which may not be deducted currently would be 
accumulated in a "deferred deduction account" and would be deducti- 
ble when the taxpayer received income from the film or similar prop- 
erty. The deferred deduction account would terminate at the earlier of 
{a) the close of the first taxable year following any taxable year by 
the close of which 95 percent or more of the income forecast for the 
film has been received (this would not operate to make the deduc- 
tion available sooner than the second taxable year after the film is 
placed in service) or (&) the close of the seventh taxable year follow- 
ing the year in which the film is placed in service. 



120 

In the case of deductions for depreciation, LAL would apply to all 
films except those with respect to which the principal production began 
before September 11, 1975, for which a binding contract for the pur- j 
chase of the film was also executed before that date. In the case of , 
deductions attributable to production, distribution or displaying costs, 
LAL would apply to all films except those with respect to which the 
principal production began before September 11, 1975. However, LAL ' 
would not apply to deductions attributable to producing a film the t| 
principal photography of which began on or before December 31, 1975 if 
if (a) on September 10, 1975, there was an agreement with the director | 
or a principal motion picture star, or on September 10, 1975, not less i 
than the lower of $100,000 or 10 percent of the estimated production ^ 
costs had been expended (or committed) and if (5) production takes | 
place in the United States. This transition rule applies only to tax- j 
payers who held their interests on December 31, 1975. Ii 

5. Equipment leasing ? 

A limitation on artificial losses (LAL) would apply to equipment [ 
leasing on a property-by-property basis. LAL would apply to both "net 
lease" financing transactions and to "operating" leases. The accelerated > 
deductions attributable to an equipment lease would be deferred to a 
later taxable year to the extent these deductions exceed the tax- 
payer's net related income from that property. Net related income from 
a leased property is gross income from the property less the "ordinary 
deductions" attributable to that property (deductions other than the 
accelerated deductions). The limitation would not apply to true eco- 
nomic losses which would continue to be deductible currently. 

The accelerated deductions to be taken into account under LAL for 
equipment leasing would be the deductions claimed for accelerated 
depreciation and amortization to the extent these deductions exceed 
those allowable under the straight line depreciation method. The op- 
tional 20-percent variance in useful lives, authorized under the ADR 
rules, would not be allowed for purpose of computing straight-line 
depreciation. This definition reflects the decision to consider the use 
of shortened depreciable lives for leased equipment, under the Asset 
Depreciation Range rule, as a facet of the accelerated deductions. 
Bonus or additional first-year depreciation under Code section 179 is 
also considered to be a part of the accelerated deductions to the extent 
it has been allowed as a deduction by an investor for a particular tax- 
able year. 

In general, LAL would apply to amounts paid or incurred after 
September 10, 1975. However, LAL would not apply to leases entered 
into before September 11, 1975, with respect to taxpayers who held 
their interests in the property (i) on September 11, 1975, or (ii) in the 
case of property placed in service before January 1, 1976, on Decem- 
ber 31, 1975. LAL would also not apply to leases where the property 
was ordered by the lessor or the lessee before March 11, 1975, and such 
property is placed in service before January 1, 1976, with respect to 
taxpayers who held their interests in the property on December 31, 
1975. In addition, LAL would not apply to leases where the lessor is 
a partnership formed before September 11, 1975, for the purpose of 
acquiring and leasing personal property, if the property was ordered 



121 

by the lessee before September 11, 1975, and the property is placed in 
service before January 1, 1976. This transition rule would apply only 
with respect to taxpayers who held their interests in the property on 
December 31, 1975. 

6. Sports franchises 

In the case of sports franchises, the amount that would be subject 
to LAL would be the amount paid by the buyer for the purchase of a 
sports franchise which is allocated to player contracts less the sum of 
the adjusted basis of the player contracts in the hands of the seller 
and any gain recognized by the seller as ordinary income with respect 
to the player contracts. The portion of this amount otherwise allow- 
able as a depreciation deduction for a year would be placed in a "de- 
ferred deduction account" to the extent that the deduction exceeds the 
taxpayer's net related income from the sports franchise for that year. 
Amounts placed in the deferred deduction account would be allowed as 
a deduction in later years to the extent that income from the sports 
franchise exceeds deductions in those later years. 

This provision would apply only to sports franchises established or 
transferred after November 4, 1975, except for sports franchises estab- 
lished or transferred pursuant to a binding contract in existence on 
such date. 



12. HOUSE BILL— OTHER TAX SHELTER PROVISIONS 

The House-passed bill includes a number of provisions to deal with 
other aspects of tax shelters. These are briefly described below. 

1. Recapture of depreciation on real property 

Under the House bill (sec. 201) , in the case of residential real estate, 
all depreciation in excess of straight line depreciation would be com- 
pletely recaptured to the extent of any gain realized at the time of the 
sale of such property. (This rule presently applies in the case of non- 
residential property). In the case of low-income housing which is 
subsidized under Federal, State, or local law, the depreciation in ex- 
cess of straight line to be recaptured would be reduced by one per- 
centage point for each full month that the property is held beyond 
100 months (8l^ years). Thus, there would be no recapture of the low- 
income housing is held 16% years. In the event of foreclosure, the 
percentage reduction would cease at the commencement of foreclosure 
proceedings. 

These provisions would apply for taxable years ending after De- 
cember 31, 1975 (regardless of the date the property was constructed) . 
The foreclosure rule would apply to proceedings which begin after 
December 31, 1975. 

2. Gain from dispositions of interest in oil and gas property 
Under the House bill (sec. 202), any gain on the disposition of an 

interest in oil or gas properties (or an interest in an oil and gas ven- 
ture) would be treated as ordinary income to the extent of the excess 
of the intangible drilling deductions taken with respect to those prop- 
erties over the deductions that would have been allowed had the ex- 
penses been capitalized. This recapture rule is similar to the recap- 
ture rule which already applies to depreciation to prevent the conver- 
sion of ordinary income into capital gain. 

These rules would apply with respect to costs paid or incurred after 
December 31, 1975, in taxable years ending after such date. 

3. Farm excess deductions account 

Under the House bill (sec. 203), because farm losses were included 
in the limitation on artificial losses (LAL), no additions would be 
made to the farm excess deduction account for any taxable year begin- 
ning after December 31, 1975. 

Jf.. Method of accounting for corporations engaged in farming 
Under the House bill (sec. 204), corporations engaged in farm 
operations, other than subchapter S corporations and family corpora- 
tions, would be required for tax purposes to use accrual and inventory 
accounting methods and capitalize certain preproductive period 
expenses for their farm operations. A family corporation for 
this purpose would be defined as one in which at least 66% percent 

(123) 



124 



of the voting stock and 66% percent of the total stock in a corporation f 
owned by a single family, including brothers and sisters, spouses, '' 
ancestors, and lineal descendants, an estate of any of these family 
members and trusts for the benefit of such family members. For pur- , 
poses of the family corporation rule, two families would be treated as j 
a single family in the case of existing holdings if certain conditions ,, 
are satisfied and, in the case of certain existing holdings stock would ,; 
be treated as held by the family if it is held by an employee of the .1 
corporation, by a member of the family of such employee or by a quali- 1 
fied trust for the benefit of employees. A corporation which elects the j| 
exception under this provision would be subject to the LAL rules on 1 
farm losses. j 

This provision would apply to taxable years beginning after Decem- | 
ber 31, 1975. However, a corporation would be allowed 10 years to 
spread the accounting adjustments required by this change in method. 

•5. Treatment of prepaid interest 

Under the House bill (sec. 205) , taxpayers using the cash method of 
accounting would be permitted to deduct prepayment of interest only 
in the period to which it relates under an accrual method of account- 1 
ing. Points (that is additional interest charges which are usually paid j' 
when the loan is closed and Avhich are generally in lieu of a higher 1 
interest rate) would be required to be deducted ratably over the term | 
of the loan, except in the case of a mortgage secured by the taxpayer's 
principal residence. In addition, the prepayment of interest rule would , 
apply to any prepayment involved in a wraparound mortgage. i 

These provisions would apply to any prepayment of interest after |l 
September 16, 1975, in taxable years ending after such date. However, 
this provision would not apply to amounts paid before January 1, 
1976, pursuant to a binding contract or written loan commitment in 
existence on September 16, 1975 (and at all times thereafter) which 
required prepayment of interest by the taxpayer. 

6. Limitation on nonbusiness interest deduction 

Under the House bill (sec. 206) , a limitation of $12,000 a year would 
be imposed on the amount of nonbusiness interest (including invest- 
ment interest) that an individual can claim as a deduction. 

In the case of a loan for investment purposes, interest on the loan 
would be deductible to the extent of the investment income, in addi- 
tion to the $12,000 allowable as a deduction under the general rule. 
Deductions for investment interest which cannot be utilized (due to the 
limitation described above) would be available as carryforwards and 
deductible in future years to the extent of related investment income 
in those years. Interest on borrowings incurred in connection with a 
taxpayer's trade or business would not be subject to these rules and 
would continue to be deductible as under present law. These rules would 
not apply to interest on installment payments of the estate tax. 

These rules would apply to taxable years beginning after Decem- 
ber 31, 1975. However, these rules would not apply to interest incurred 
before September 11, 1975 or interest incurred after September 11, 
1975 pursuant to a written contract or commitment which on Septem- 
ber 11, 1975 and at all times thereafter is binding on the taxpayer 
(however, the limitation of section 163(d) of the Internal Revenue 
Code would continue to apply as under present law) . 



125 

7. Limitation of loss with respect to motion picture films or livestock 

or certain crops to the amount for which the taxpayer is at risk 
Under the House bill (sec. 207) , to deal with the problem of leverage, 
a limitation would be imposed on the deduction of losses in the case of 
motion picture films and similar productions, livestock other than poul- 
try and certain crops including grain, oil seed, fiber, pasture, tobacco, 
siiage, or forage crops. The deduction of losses would be limited to the 
amount for which the taxpayer is "at risk", excluding all nonrecourse 
loans. This proposal would affect the leverage factor which is present 
in the film purchase shelter, the production company shelter and certain 
livestock and crop shelters. 

In general, this provision would apply to amounts paid or incurred 
after September 10, 1975, in taxable years ending after such date. 
However, this provision would not apply to a film or video tape if {a) 
the principal production began on or before September 10, 1975 or (&) 
on September 10, 1975, there was a binding agreement providing for 
nonrecourse financing for the film in question. In addition, LAL would 
not apply to losses attributable to producing a film the principal pho- 
tography of which began on or before December 31, 1975 if {a) on 
September 10, 1975, there was an agreement with the director or a 
principal motion picture star, or on September 10, 1975 not less than 
the lower of $100,000 or 10 percent of the estimated production costs 
had been expended or committed and if (?>) production takes place in 
the United States. This transition rule would only apply with respect 
to taxpayers who held their interests on December 31, 1975. 

8. Deduction for intangihle clrilling and development costs allowable 

only to taxpayers at risk 

To deal with the problem of leverage, the House bill (sec. 208) limits 
the deduction for intangible drilling and development costs at- 
tributable to a property to the amount for which the taxpayer is "at 
risk" with respect to that property. Thus, a taxpayer would be allowed 
a deduction only to the extent of his own equity investment in the part- 
nership. The taxpayer would not be allowed to deduct expenses paid 
out of borrowed funds, unless the taxpayer had some personal liability 
with respect to those borrowings. 

This provision would apply to amounts paid or incurred after De- 
cember 31, 1975, in taxable years ending after such date. 

9. Player contracts in the case of sports enterprises 

Allocation of purchase pnce to player contracts. — Under the House 
bill (sec. 209), in the case of sports enterprises, the portion of the 
amount paid to purchase a sports team or group of assets which would 
be allocable to player contracts or sports enterprises must be specified. 
The provision would have a presumption that not more than 50 per- 
cent of the purchase price could be allocated by the buyer to players' 
contracts unless the buyer can establish under the facts and circum- 
stances of the case that the players' contracts involved do have a value 
in excess of 50 percent of the purchase price. In addition, the amount 
allocable to player contracts by a purchaser could not in any event 
exceed the amount of the sales price allocated to these contracts by the 
seller. 



126 

This provision would apply to franchises sold or exchanged after 
December 31, 1975, in taxable years ending after such date. 

Recapture of depreciation on player contracts. — In the case of play- 
er contracts or sports franchises, the House bill clarifies present law by 
providing a complete recapture of all depreciation to the extent of any 
gain involved at the time of the sale of the player contract or of the 
sports enterprise. 

This provision would apply to taxable years beginning after De- 
cember 31, 1962. 

The House bill also provides for the complete recapture of all 
previously unrecaptured depreciation on the sale of a player con- 
tract or a sports franchise. Under this provision, the term previously 
"unrecaptured depreciation" means the sum of the depreciation allowed 
or allowable with respect to player contracts after December 31, 1975, 
and the deductions allowed for losses with respect to player contracts 
incurred after December 31, 1975, less the aggregate of amounts re- 
captured as ordinary income with respect to prior dispositions of 
player contracts. Thus, to the extent of any gain recognized with re- 
spect to the sale of player contracts, the amount of the deductions al- 
lowed as either depreciation or a loss shall be recaptured as ordinary 
income even though some or all of the players with respect to whose 
contracts the deductions were allowed are no longer under contract 
with the sports franchise. 

W. Certain partnership provisions 

Under the House bill (sec. 210), several aspects of the partnership 
tax rules would be revised. First, income or losses would be allocable 
to a partner only if they are paid or incurred (by the partnership) dur- 
ing the portion of the year in which he is a member of the partnership. 
In determining whether income, loss or a special item has been paid or 
incurred prior to a partner's entry into a partnership, the partnership 
may either allocate ratably on a daily basis or, in effect, separate the 
partnership year into two (or more) segments and allocate income, 
loss, or special items in each segment among the persons who were 
partners during that segment. 

Second, income, losses, or items of income, gain, loss, deduction or 
credit generally must be allocated among the partners (1) in accord- 
ance with the permanent method for allocating income, if any, or 
(2) if there is no such permanent allocation of income, on the basis of 
the partners' capital. This rule would not apply, however, if the part- 
ner receiving the special allocation can establish that there is a busi- 
ness purpose for allocating the loss or item otherwise and no significant 
tax avoidance results from this allocation. 

Third, the amount of additional first-year depreciation that a part- 
nership can pass through to its partners in any taxable year would be 
limited. A limitation of $2,000 would be imposed on the amount of 
additional first-year depreciation at the partnership level as well as at 
the partner level. Thus, a partnership could pass through to each part- 
ner his pro rata share of the $2,000 bonus depreciation allowance. An 
individual then would aogregate all of the additional first-year depre- 
ciation from all partnersliips in which he was a member, but this aggre- 
gate amount for which deductions may be taken may not exceed $2,000 
(or $4,000 in the case of a joint return) . 



127 

Finally, fees for the organization and syndication of a partnership 
must be capitalized. 

These provisions, except to the extent they are declaratory of exist- 
ing law, would be effective for taxable years of partnerships beginning 
after December 31, 1975. 

11. Scope^ of waiver of statute of limitations in case of hohhy loss 
elections 

Under the House bill (sec. 211), in giving the taxpayer an oppor- 
tunity to determine whether he has satisfied the rule of present law 
limiting deductions incurred in an activity which is not engaged ia 
for profit (Code section 183), on the basis of his experience in a 5- 
or 7-year period, the waiver of the statute of limitations in these cases 
would be limited so that the waiver does not apply to unrelated items 
on the taxpayer's return. 

In general, this provision would apply to taxable years beginnine 
after December 31, 1969. " ./ ^ & 

O